Canadian Bank Primer, Sixth Edition

RBC Dominion Securities Inc. Andre-Philippe Hardy, CFA Michael Loewen, CFA (Analyst) (Associate) (416) 842-4124 (416) 842-7815 [email protected] [email protected] Robert Poole, CFA (Associate) (416) 842-5638 [email protected] September 18, 2013 Canadian Bank Primer, Sixth Edition An in-depth review of Canadian banks RBC Capital Markets’ Canadian Bank Primer examines the fundamentals of the Canadian banking sector in detail. The primer should be particularly useful to investors who are not overly familiar with Canadian banks and/or banks in general, or those who wish to refresh their knowledge base and gain a better understanding of selected topics. Our extensive data history also helps to put

EQUITY RESEARCH EQUITY today’s opportunities and challenges in a broader context rather than simply looking at what may or may not happen in the short term.

This primer provides an overview of the banking landscape in Canada, recent history, valuation, financial statements, major operating divisions, risks and metrics to monitor, and upcoming regulatory capital changes, among other items. After reading this primer, investors should have a better understanding of:

• How the banks have changed in the last 25 years. For example, we show that banks are less exposed to traditional credit risk than in the past, have stronger capital positions, and have shifted their business mix to less spread-dependent wealth management and capital markets businesses. • Metrics to focus on from a valuation perspective, and when to buy banks (or not). Price-to-earnings valuation is the most commonly used metric to value banks, but it is not always the best one, especially in times of economic and/or capital markets stress. The valuation section also covers why we think Canadian banks should trade at higher valuations than in the 1990s. • How the banks make money in their various businesses. Retail banking is the largest earnings contributor, followed by wholesale banking (capital markets), wealth management, and insurance at some banks. Profitability in retail banking depends on the strength of the economy, wealth management profitability is closely linked to the direction of equity markets and, to a lesser extent, interest rates, while wholesale banking—the most difficult division to forecast because of the volatility of earnings and opacity of certain activities—is usually correlated to institutional risk appetite, asset values, and corporate investment cycles. • How to predict the direction of loan losses by looking at macro factors and bank disclosures to identify trends and compare them with prior credit cycles. The metrics we monitor indicate that credit quality should remain benign and provision for credit loss ratios should remain near current levels. • How to determine appropriate capital levels to guard against expected and unexpected risks inherent in the banks’ businesses. Canadian banks are well capitalized and all meet the current Basel III capital rules, which were introduced in Canada in Q1/13. • Important differences compared to US banks.

In this edition of the Canadian Bank Primer, in addition to updating our views on many issues that we explored in earlier editions, we discuss the most recent information available on regulatory changes, including buffers for domestic systematically important banks, liquidity rules, leverage ratios, non- viability contingent capital and bail-in debt. We have also incorporated a section on the potential impact of higher interest rates on the Canadian banks, and a section on credit card interchange fees and the potential implications of changes in payment mix on Canadian retail banking revenues.

Priced as of prior trading day's market close, EST (unless otherwise noted). All values in CAD unless otherwise noted. For Required Non-U.S. Analyst and Conflicts Disclosures, see page 238. Canadian Bank Primer, Sixth Edition

Table of Contents Introduction and Report Summary ...... 4 Summary of Report Sections ...... 5 SECTION 1: Individual bank highlights ...... 7 Bank Summaries ...... 9 Bank of Montreal ...... 9 Scotiabank ...... 10 CIBC ...... 11 National Bank of Canada ...... 12 Royal Bank of Canada ...... 14 TD Bank ...... 15 Canadian Western Bank ...... 16 Laurentian Bank ...... 17 SECTION 2: Income statements, balance sheets, and capital ...... 19 How banks make money: A simplified income statement...... 19 Leverage is high, but banks must meet capital requirements ...... 20 Banks operate in three main business lines ...... 24 Key measures of consolidated profitability to track ...... 25 SECTION 3: The Canadian Landscape ...... 33 Regulation – Key things to know...... 43 History: Since 1990 ...... 44 SECTION 4: Retail banking is the largest earnings contributor ...... 64 Net interest income accounts for 70–75% of retail revenues ...... 64 Non-interest income contributes 25-30% of retail revenues ...... 75 Mortgages and credit cards are key retail lending products ...... 76 Retail loans are mostly funded with retail deposits ...... 86 SECTION 5: Wholesale banking is banks’ second-largest division ...... 92 Advisory and underwriting have low capital requirements ...... 94 Trading businesses are volatile from quarter to quarter ...... 97 Corporate lending ROEs have improved ...... 107 Derivatives both reduce and increase risk for banks ...... 110 Securities accounting and understanding disclosures ...... 115 SECTION 6: Wealth management: Profitable contributor ...... 128 Canadian banks are the leaders in retail brokerage ...... 130 Banks’ positioning in Canadian mutual funds is strong ...... 134 SECTION 7: Loan losses can be material, but exposure has declined ...... 137 Credit risk varies by loan type ...... 141 Mortgages have the least credit risk ...... 142 Consumer loans have more credit risk than mortgages ...... 146 Business loan losses have been most volatile historically ...... 149 Key credit ratios to monitor and accounting treatment ...... 153 How to use available disclosures ...... 158 Our current view on credit is for continued stability ...... 163 SECTION 8: Capital supports both expected and unexpected risks ...... 167 Regulatory capital requirements based on risk profiles ...... 168 Basel III regulatory capital requirements are more restrictive ...... 172 Canadian banks are well capitalized ...... 174 Key capital indicators to monitor ...... 178 Economic and rating agency capital requirements matter ...... 184 Not all banks should have the same capital levels...... 185 Expected changes to regulatory requirements ...... 186

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SECTION 9: Valuation – Metrics to track and when to buy (or not)...... 191 Price-to-earnings valuation is most commonly used ...... 191 Price-to-book valuation matters in uncertain times ...... 196 Dividend-yield valuation metrics less useful, in our view ...... 197 When to buy banks (or not) ...... 198 Assessing risk/reward in volatile times ...... 206 SECTION 10: Overview of major risks ...... 208 Credit risk is the biggest risk for banks ...... 208 Requirements for operational risk were introduced in 2008 ...... 209 Market risk-weighted assets increased in Q1/12 ...... 209 Liquidity risk: Concept became reality in 2007-2008 ...... 210 SECTION 11: Key differences with US banks ...... 215 Banking market is consolidated in Canada ...... 215 Canadian banks are more diversified...... 215 Canadian banks’ assets: Less risk but lower margins ...... 217 Canadian banks have traded at higher valuations ...... 220 2008-2010 was a different experience for Canadian banks ...... 221 Canadian banks account for a greater weight of the index ...... 222 Mortgage markets are very different ...... 222 SECTION 12: Glossary and Acronyms ...... 227

In all jurisdictions where RBC conducts business we do not offer investment advice on Royal Bank. Certain regulations prohibit member firms from soliciting orders and offering investment advice or opinions on their own stock. References to Royal Bank are for informational purposes only and are not intended as a direct or implied recommendation for investing in Royal Bank and all related securities.

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Introduction and Report Summary RBC Capital Markets’ Canadian Bank Primer examines the fundamentals of the Canadian banking sector in detail. The primer should be particularly useful to investors who are not overly familiar with Canadian banks and/or banks in general, or those who wish to refresh their knowledge base and gain a better understanding of selected topics. Our extensive data history also helps to put today’s opportunities and challenges in a broader context rather than simply looking at what may or may not happen in the short term.

This primer provides an overview of the banking landscape in Canada, recent history, valuation, financial statements, major operating divisions, risks and metrics to monitor, and recent and upcoming regulatory capital changes, among other items. A glossary and a list of commonly used acronyms are provided at the end of this report.

 This report is not intended to be an update on stock recommendations or profitability forecasts for individual banks. We regularly update our views on individual Canadian banks; for our latest views on the industry and individual banks, including ratings and price targets on individual banks, please contact us or your RBC Capital Markets salesperson.

This is the sixth edition of the Canadian Bank Primer, which we will continue to update on a yearly basis. If there are topics that you would like us to cover in greater detail, or if there are topics that you feel were not addressed, please let us know, and we will consider your feedback for next year’s update.

This year’s primer has been updated for the following:

 Our section on capital reflects the most recent information available on regulatory changes, including buffers for domestic systematically important banks, liquidity rules, leverage ratios, non-viability contingent capital and bail-in debt.  We incorporated a section on the potential impact of higher interest rates on Canadian banks.  We have included a section on credit card interchange fees and the potential implications of a change in payment mix on Canadian retail banking revenues.

For those looking for a comprehensive source of data that is useful for bank analysts, we publish on a quarterly basis our Canadian Bank Chart Book, which offers a detailed compilation of historical data on topics including valuation, profitability, credit, capital, and funding, as well as economics. Please contact us or your RBC Capital Markets salesperson if you would like to receive a copy of that report.

We also wish to acknowledge the contribution of certain colleagues, particularly Geoffrey Kwan, whose work on Canadian housing and asset management is part of what makes this primer comprehensive, as well as Fiona Swaffield, who provided valuable insights on the wholesale/capital markets section, and Altaf Nanji for his help on funding. Exhibit 184 provides an overview of RBC Capital Markets’ extensive global financial services research platform.

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Summary of report sections SECTION 1: Individual bank highlights In this section, we provide key financial highlights for the Canadian banks, which should be of use to investors who are not familiar with Canadian banks. We regularly update our outlook on individual Canadian banks, which is not the purpose of this report. For our latest view on the industry, including ratings and price targets on individual banks, please contact us or your RBC Capital Markets salesperson. SECTION 2: Income statement, balance sheet, and capital In this section, we provide a basic overview of how banks make money by going over major income statement items, such as net interest income and non-interest income, operating expenses, provisions for credit losses, and taxes. We also provide a brief overview of the leverage banks employ and how they are subject to capital requirements. Lastly, we detail the key ratios to look at (and our outlook) when measuring profitability, including net interest income margins, the efficiency ratio, return on assets (ROA), fee income to total income, and return on equity (ROE). SECTION 3: The Canadian landscape This section addresses the size of the Canadian banks, their importance in Canadian financial services, and the Canadian stock market. We detail key regulatory issues and provide a historical overview of bank profitability, capitalization, and milestones. SECTION 4: Retail banking is the largest earnings contributor Retail banking operations consist of branch banking and online banking, with products including mortgages, credit cards, lines of credit, term loans, and deposits (transaction and savings). Small business and commercial operations are generally also considered to be part of retail banking, while financial planning activities are mostly reported in wealth management divisions, but much of the activity takes place in the banks’ branch networks. Retail banking businesses account for about 50–70% of the banks’ income. SECTION 5: Wholesale banking is the second-largest division Wholesale banking accounts for 15–40% of income in normal years, depending on the bank. Wholesale (or capital markets) divisions deal with corporate and institutional clients, and revenue-generating activities include corporate lending, trading, underwriting, and advisory (i.e., M&A). Most banks have had a merchant banking or private equity arm as well, but those were/are generally small and have been, or are being, de-emphasized (largely due to regulatory changes). Approximately 30–50% of Canadian banks’ wholesale revenues come from trading, while 20–40% is from advisory, underwriting, and other market activities, and 10–40% is from corporate lending. SECTION 6: Wealth management: profitable contributor The wealth management divisions of the banks, which contribute 10–20% of income in normal times, generate most of their revenues from retail brokerage and asset management, mainly mutual funds. The banks also provide private client and trust services, but those are not as meaningful in contributing to the bottom line. Investors normally value wealth management companies at higher multiples than traditional banking and/or investment banking.

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SECTION 7: Loan losses can be material, but risk has declined Past credit cycles resulted in severe losses for Canadian banks and banks will always have credit risk as it is one of the primary reasons why they exist, so it is important to take credit risk into consideration when investing in banks. This section focuses on: 1) how banks are exposed to credit risk; 2) the variability in credit risk by loan category and useful predictive loss metrics; 3) how to use available disclosures to predict credit losses; 4) key credit ratios; and 5) accounting for credit-related items under IFRS. We also provide our outlook for loan losses in upcoming years. SECTION 8: Capital supports both expected and unexpected risks Banks need to hold capital in order to guard against the expected and unexpected risks inherent in their businesses, including credit risk, operational risk, market risk, and liquidity risk. This section reviews: 1) how regulatory capital is determined under the Basel III rules; 2) key capital indicators to track to determine capital strength; 3) the effect of new rules that have been introduced or are about to be introduced, on excess capital, capital deployment, and ROE; 4) how banks consider economic capital and rating agency capital requirements as supplementary constraints to regulatory capital requirements; and 5) future regulatory changes expected for liquidity, centralized counterparties for over-the-counter (OTC) derivatives, and countercyclical capital buffers. SECTION 9: Valuation – Metrics to track and when to buy (or not) The valuation section covers: 1) the three main valuation metrics that are used for banks (price-to-earnings, price-to-book, and dividend yields); 2) when it is time to buy banks (or not); 3) why we think banks should trade at higher valuations than in the 1990s, but not as high as in the 2003 –2007 period; and why we believe higher interest rates would be good for banks. SECTION 10: Overview of major risks Banks are exposed to a multitude of risks, which is why they must have well rounded risk- management infrastructures, are heavily regulated, and must hold capital and liquidity reserves. The four main sources of risk, in our view are: credit risk, market risk, operational risk, and liquidity and funding risks. Credit risk represents about 81% of banks’ regulatory capital requirements under current rules, operational risk 13%, and market risk 6%. There are currently no global regulatory requirements for liquidity and funding risks, although that will likely change under the new Basel proposals. SECTION 11: Key differences compared to US banks This section highlights key differences between the Canadian and US banking systems, including a detailed discussion of the two residential mortgage markets. The section should be of particular interest to investors familiar with US banks but not the Canadian banks. We also highlight how Canada-focused investors have a narrower range of industries to invest in than US-focused investors, which helps Canadian bank shares in downturns. In addition, we highlight relative historical valuations. SECTION 12: Glossary and Acronyms Investors unfamiliar with banks may find this section useful if looking for a technical term or an acronym.

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SECTION 1: Individual bank highlights Big Six banks Regional banks

Bank of Canadian As at fiscal Q3/13 unless otherwise noted Montreal Scotiabank CIBC National Bank Royal Bank1 TD Bank Western Bank Laurentian Bank Exchanges TSX and NYSE TSX and NYSE TSX and NYSE TSX TSX, NYSE and SWX TSX and NYSE TSX TSX Ticker (TSX) BMO BNS CM NA RY TD CWB LB Market capitalization (as at Sep 09, 2013) $43,349 $72,185 $32,920 $13,606 $95,599 $84,210 $2,405 $1,268 Fiscal year end October 31 October 31 October 31 October 31 October 31 October 31 October 31 October 31 Q3/13 Assets ($mm) 549,331 742,625 397,547 187,179 867,530 835,101 17,927 33,759 Q3/13 Risk weighted assets($mm) 214,233 282,309 133,994 60,040 314,804 283,521 15,846 13,472 Employees (Q3/13) 46,628 83,416 43,516 16,796 75,376 78,917 2,007 4,289 Business relative size Approximate income contribution (average 2010 - 2012) Canadian retail banking (core earnings) 48% 35% 65% 48% 50% 50% 100% 93% US/International retail banking (core earnings) 8% 26% 6% 0% 1% 19% 0% 0% Wealth management (core earnings) 13% 12% 8% 12% 11% 16% 0% 0% Insurance/Other (core earnings) 0% 0% 0% 0% 9% 0% 0% 0% Wholesale banking (core earnings) 31% 27% 21% 41% 29% 17% 0% 7% Revenue mix (Reported, median 2010 - 2012) Net interest income % of revenue 54% 52% 57% 47% 41% 63% 83% 67% Core earnings outside Canada (2012) 30% 46% 17% 1% 20% 34% min. min. Assets and Loans Loan Mix EOP Total Loans $264,986 $400,442 $245,156 $88,026 $404,141 $436,631 $15,367 $26,779 EOP Residential Mortgages $96,211 $208,931 $149,440 $35,896 $206,441 $181,510 $2,410 $14,149 EOP Personal Loans (excl cr. Cards) $63,230 $69,789 $34,532 $25,665 $94,191 $119,260 $132 $7,412 EOP Business & Gov't $97,744 $118,322 $46,384 $24,554 $89,628 $114,358 $12,957 $5,167 Credit Cards $7,801 $3,400 $14,800 $1,911 $13,881 $21,503 n/a n/a EOP Personal Loans (incl. cr. Cards) $71,031 $73,189 $49,332 $27,576 $108,072 $140,763 $132 $7,412

Residential Mortgages 36% 52% 61% 41% 51% 42% 16% 53% Personal Loans (excl Credit Cards) 24% 17% 14% 29% 23% 27% 1% 28% Business and Government 37% 30% 19% 28% 22% 26% 84% 19% Credit Cards 3% 1% 6% 2% 3% 5% n/a <1% U.S. loans as % of Total Loans 26% 6% 3% 0% 5% 23% n/a n/a Ontario loans as % of Total Loans (2012) 29% 34% 45% n/a 41% 65%* 10% Quebec: 61% Rest of Canada loans as % of Total Loans (2012) 48% 37% 51% n/a 51% 12% 90% 39% Total loans (2012) 247,522 355,456 244,156 83,249 380,241 411,492 13,896 26,570 Ontario loans (2012) 70,851 120,248 108,861 n/a 154,774 268,471 1,404 Rest of Canada loans (2012) 118,489 131,652 123,955 n/a 192,060 49,101 12,493 Credit reserves Total allowance vs Historical PCL 2.8 years 4.5 years 3.9 years 2.2 years 2.2 years 2.4 years 2.7 years 2.2 years

1.Royal Bank of Canada is not rated because RBC Capital Markets does not provide investment recommendations or forecasts for it. *TD Bank's Ontario loans are based on the geographic location of the unit responsible for recording the revenue and overstates the banks Ontario exposure. Source: Company reports, Thomson One, SNL, OSFI, RBC Capital Markets estimates. Continued on next page… September 18, 2013 7 Canadian Bank Primer, Sixth Edition

Big Six banks Regional banks

Bank of Canadian As at fiscal Q3/13 unless otherwise noted Montreal Scotiabank CIBC National Bank Royal Bank1 TD Bank Western Bank Laurentian Bank Capital and Funding Reported Basel III Common Equtiy Tier 1 Ratio 9.6% 8.9% 9.3% 8.6% 9.2% 8.9% 7.8% 7.5% Tier 1 Ratio 11.2% 11.0% 11.6% 11.4% 11.3% 11.0% 9.6% 9.0% Assets to Regulatory Capital 16.2x 17.1x 18.1x 18.0x 16.8x 17.7x 8.0x 17.2x RWA / Total Assets 39.0% 38.0% 33.7% 32.5% 37.0% 34.0% 88.4% 39.9% Deposit funding Retail deposits to retail loans 103% 86% 71% 74% 81% 109% 96% 90% Retail deposits to total loans 75% 67% 68% 71% 78% 96% 96% 90% Valuation (as at Sep 09, 2013) Current Forward P/E 10.4x 10.9x 9.9x 9.6x n/a 10.8x 11.0x 8.1x 10 year Average 11.4x 12.1x 10.7x 10.3x 12.0x 11.6x 13.8x 11.6x Current P/B 1.6x 1.8x 2.1x 1.9x 2.2x 1.8x 1.8x 1.0x 10 year Average 1.9x 2.4x 2.4x 1.9x 2.5x 2.0x 2.1x 1.0x Current P/TB 1.9x 2.6x 2.4x 2.5x 2.9x 2.7x 1.9x 1.2x 10 year Average 2.2x 2.7x 2.8x 2.4x 3.3x 3.5x 2.1x 1.0x Current Dividend Yield 4.4% 4.1% 4.7% 4.2% 4.0% 3.7% 2.4% 4.5% Profitability ROE 2008 15.0% 21.3% 22.6% 19.1% 22.8% 15.8% 16.0% 10.4% (reported) 2009 13.2% 17.5% 19.7% 19.7% 20.2% 12.3% 13.4% 8.5% 2010 15.1% 18.7% 21.8% 17.9% 17.2% 13.9% 16.6% 11.0% 2011 16.0% 19.4% 24.8% 20.9% 20.4% 17.3% 16.2% 12.2% 2012 15.5% 17.6% 22.6% 20.6% 19.8% 16.3% 15.6% 11.9% ROA 2008 0.55% 0.86% 0.74% 0.68% 0.86% 0.86% 1.04% 0.47% (reported) 2009 0.51% 0.69% 0.60% 0.71% 0.90% 0.75% 0.87% 0.38% 2010 0.68% 0.80% 0.74% 0.73% 0.84% 0.86% 1.19% 0.47% 2011 0.65% 0.81% 0.76% 0.71% 0.84% 0.88% 1.21% 0.43% 2012 0.72% 0.81% 0.82% 0.71% 0.90% 0.85% 1.13% 0.41% RORWA 2008 1.14% 1.56% 2.16% 1.50% 2.01% 1.97% 1.77% 0.92% (reported) 2009 1.33% 1.59% 1.81% 1.71% 2.51% 2.31% 1.08% 0.82% 2010 1.68% 1.91% 2.41% 2.05% 2.19% 2.54% 1.44% 1.09% 2011 1.47% 2.02% 2.73% 2.34% 2.45% 2.81% 1.47% 1.10% 2012 1.89% 2.11% 2.83% 2.29% 2.60% 2.76% 1.38% 1.04% Other Efficiency ratio (LTM) 64% 53% 59% 60% 60% 60% 45% 74% Dividends per share $0.72 $0.57 $0.94 $0.79 $0.60 $0.77 $0.16 $0.47 Payout ratio (NTM Net Income) 48% 47% 47% 53% 33% 46% 30% 40% Payout ratio (LTM Core Cash Net Income) 48% 48% 45% 51% 47% 41% 29% 39% Last stated target 40%-50% 40%-50% 40%-50% 40%-50% 40%-50% 40%-50% 25%-30% 40%-50%

1Royal Bank of Canada is not rated because RBC Capital Markets does not provide investment recommendations or forecasts for it. Source: Company reports, Thomson One, SNL, OSFI, RBC Capital Markets estimates.

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Bank summaries Bank of Montreal Description Bank of Montreal (BMO) is Canada’s fourth-largest bank by market capitalization ($43 billion) and by assets ($549 billion). It currently has 937 domestic branches and 634 branches in the US, with approximately 46,600 employees. The bank’s group of companies include the Chicago-based BMO Harris Bank; BMO Nesbitt Burns, a full-service investment firm; and BMO Capital Markets. Our 2013 estimated earnings mix is as follows: Canadian retail banking 41%; US retail banking 17%; wealth and insurance 17%; and wholesale 25%.

The bank operates primarily in Canada and the US, but it also has small operations in the UK, Europe, and Asia. In Canada, Bank of Montreal is a large player in almost all retail and wholesale businesses. It is generally known as being the largest MasterCard issuer and also as having one of the larger small business and commercial lending platforms among the banks. In the US, the bank has a Midwest retail banking franchise, as well as capital markets and wealth management businesses.

History Established in 1817, Bank of Montreal is one of Canada’s older banks. In the past few decades, the bank made some domestic acquisitions including Nesbitt Burns (retail brokerage and capital markets), Guardian Group of Funds (asset management), and AIG Life Insurance Company of Canada. Outside Canada, the bank made a number of large acquisitions including Marshall & Ilsley for US$4.1 billion in 2011, CSFBdirect in 2002 (which it later sold), and Harris Bank in 1984. The bank also acquired a number of small banks in the Midwest in the past decade including AMCORE Bank, Ozaukee Bank, Merchants and Manufacturers Bank in Milwaukee, First National Bank & Trust in Indiana, and Mercantile Bank in the Chicago area (see Exhibit 43 for a list of acquisitions). It also purchased the North American franchise of the Diners Club credit card for $840 million in December 2009.

President and Chief Executive Officer William A. Downe has been in his current position since March 2007. He has worked at the bank since 1983 in a number of roles including Chief Operating Officer, and prior to that as CEO of BMO Nesbitt Burns.

Metrics  Bank of Montreal’s domestic market share generally ranks number four or five in most retail and wholesale products. The notable exception is small business and commercial lending, where the bank has one of the largest shares along with Royal Bank and TD Bank. In wholesale businesses, the bank also generally ranks number four or five in league tables.  As of 2012, the bank’s core cash EPS four-year compound annual growth rate (CAGR) was 8.1%, which compared to a median of 6.2% and a range of 4.1–9.5% for the peer group. Over the medium term (last eight years), the bank’s EPS CAGR growth of 4.0% was below the median peer growth rate of 8.1% and below a range of 5.0–10.0% for the peer group.1  BMO’s profitability has been lower than its peer group in the last five years. Its 2012 ROE was 16% compared to 20% for its peers, and a five-year average ROE of 14% compares to 16% for the group. On a core cash basis, BMO’s 2012 ROE of 15% was below 19% for peers, and the five-year average ROE of 15% also compares to 19% for the group.

1 We use 4- and 8-year time intervals as 5- and 10-year intervals would be influenced by periods of unusually low profitability. September 18, 2013 9 Canadian Bank Primer, Sixth Edition

 Dividend growth in the last 10 years has been at the low end compared to its peers (median annual growth rate of 7% compared to a range of 4–13% for its peers). Its five- year cumulative payout ratio of 57% of core cash earnings is higher than the peer group range of 40–51%. Like all Canadian banks, Bank of Montreal has been committed to its dividend as it has not cut its quarterly dividend since the 1940s despite periods of high payout ratios. For example, BMO’s payout ratios of 65–70% in 2008 and 2009 (or 75– 90% of reported earnings) were above its industry-highest target payout range of 45– 55% (since dropped to 40-50%), but the bank maintained its dividend.  Capital ratios have been at the high end of the peer group range recently, and leverage is lower. The bank’s Basel III common equity Tier 1 ratio of 9.6% is above the peer range of 8.6–9.3%. The bank’s assets-to-capital multiple of 16.2x is lowest of the peer group (ranging from 16.8x to 18.1x), and our estimated Basel III Tier 1 leverage ratio of 4.3% is above the peer group range of 3.4% to 3.9%.

Scotiabank Description Scotiabank is Canada’s most international bank and most active corporate lender. Notable for a long track record as the low-cost Canadian producer, Scotiabank currently ranks third by market capitalization ($72 billion) and by assets ($742 billion). Scotiabank operates 3,300 branches worldwide, of which 1,037 are in Canada, and has approximately 83,000 employees.

Outside its operations in Canada, Scotiabank has a presence in more than 50 countries around the world, primarily in Latin America, the Caribbean, and Asia. In 2013, we expect the domestic bank to contribute around 31% earnings, international banking 28%, wealth management 20%, and wholesale banking 21%.

History Scotiabank was established in 1832 in Halifax, Nova Scotia, and after establishing branches across Canada by the 1900s, the bank eventually moved its head office to Toronto. The bank’s major domestic acquisitions include McLeod Young Weir (capital markets) in 1987, Montreal Trust and National Trust in the mid 1990s, and DundeeWealth in 2011. In recent years, the bank expanded its wealth management presence in Canada through its acquisition of DundeeWealth, the Canadian operations of E*Trade, and a stake in CI Financial. In November 2012, the bank completed the purchased ING Direct Canada from Netherlands- based ING Group for $3.1 billion.

Scotiabank has been an active consolidator of banks internationally. After the bank’s first foray outside of North America in 1889, when it opened a branch in Kingston, Jamaica, the bank expanded into over 25 countries in the Caribbean, Latin America, and Asia. Most acquisitions have been less than $500 million, except for its 51% stake in Banco Colpatria in Colombia for $1 billion in 2012, Siam City Bank in Thailand for a contribution of $660 million in 2009, Banco del Desarrollo in Chile for $1 billion in 2007, and Inverlat in Mexico for a total of $785 million in 2000 and 2003. (See Exhibit 43 for a list of acquisitions)

CEO Rick Waugh has been in his current position since 2003. He has worked at the bank since 1970 in a number of roles including Vice-Chairman of International Banking and Wealth Management, and prior to that as Vice-Chairman of Corporate Banking. President Brian Porter will be replacing Rick Waugh as CEO in November 2013.

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Metrics  Scotiabank’s domestic market share generally ranks number three or four in retail products. The bank used to have a small market share in mutual fund assets under management (AUM) until it acquired DundeeWealth in the second quarter of 2011. In wholesale businesses, the bank generally ranks number three to five in league tables.  As of 2012, the bank’s core cash EPS four-year compound annual growth rate (CAGR) of 4.3% was below the median of 6.2% and compared to a range of 4.1–9.5% for the peer group. Over the medium term (last eight years), the bank’s EPS CAGR growth of 6.7% was below the median peer growth rate of 8.1% and compared to a range of 4.0–10.0% for the peer group.  Scotiabank is known as a low-cost bank, and its reported profitability has been among the high end of its peer group in the last five years. Scotiabank’s efficiency ratio of 53% in 2012 was at the low end of the peer range of 51–64%. Its 2012 ROE was 20% compared to 20% for its peers, and its five-year average ROE was 19% compared to 16% for the group. On a core cash basis, Scotiabank’s 2012 ROE was 18% compared to 19% for its peers, and its five-year average ROE of 19% was also in line with the group.  Dividend growth in the past 10 years has been at the high end of its peers (median annual growth rate of 11% compared to a range of 4–13% for peers), while its five-year cumulative payout ratio of 49% is marginally above the peer group’s 47%. Scotiabank raised its quarterly dividend in the first quarter of 2013, the fourth increase since the second quarter of 2008.  Capital ratios have been in line with the peer group recently. The bank’s Basel III common equity Tier 1 ratio of 8.9% is near the middle of the group range of 8.6–9.6%. Scotiabank’s assets-to-capital multiple of 17.1x near the middle of its peer group range of 16.2–18.1x, and our estimates Basel III Tier 1 leverage ratio of 3.7% is also near the midpoint of the peer group range of 3.4%-4.3%.

CIBC Description CIBC is Canada’s fifth-largest bank as measured by market capitalization ($33 billion) and assets ($397 billion). The bank operates 1,109 Canadian branches, 75 wealth management offices, and 65 branches in its FirstCaribbean division. The company has approximately 43,000 employees and nearly 11 million personal and business customers in Canada and abroad.

CIBC derives about 67% of earnings from retail and business banking, 10% from wealth management, 2% from FirstCaribbean, and 21% from wholesale banking.

History CIBC was formed in 1961 with the merger of The Canadian Bank of Commerce (established in 1867) and the Imperial Bank of Canada (established in 1875), both headquartered in Toronto. The bank expanded into the capital markets through the acquisition of Wood Gundy in 1988. CIBC also acquired the Canadian retail brokerage division of Merrill Lynch in 2002. CIBC’s presence in the Caribbean started in the 1920s with branches opening in Cuba, Jamaica, Barbados, and Trinidad. FirstCaribbean was formed in 2002 when CIBC merged its Caribbean operations with those of Barclays.

More recently, in 2013, CIBC announced an agreement to sell approximately 50% of it Aerogold Visa credit card customers to TD Bank, representing roughly $3 billion in credit card balances. Also in 2013, CIBC announced the acquisition of Atlantic Trust, a privately owned investment manager, for $210 million. The company also purchased a 41% equity stake in American Century Investments for US$848 million in 2011, a Canadian MasterCard portfolio September 18, 2013 11 Canadian Bank Primer, Sixth Edition

from Citigroup for cash consideration of $1.2 billion in 2010, and a 22% stake in the Bank of N.T. Butterfield & Son Limited in the Caribbean for $150 million in 2010. It also bought Oppenheimer Holdings in 1997 for about $500 million (which it has since sold).

President and CEO Gerald T. McCaughey has been in his current position since August 2005. He has worked at the bank since 1981 in a number of roles including Chief Operating Officer, and prior to that as Chairman and CEO of CIBC World Markets.

Metrics  CIBC’s domestic market share generally ranks number three to five in most retail products, except for credit cards, where it has been a leading player, although has recently announced the sale of approximately $3 billion in credit card balances to TD Bank. In wholesale businesses, the bank generally ranks in the top three in league tables, but earnings contribution from wholesale businesses (about 20% of total earnings) has generally been smaller than the peer group (along with TD Bank).  As of 2012, the bank’s core cash EPS four-year compound annual growth rate (CAGR) of 4.1% was below the median of 6.2% and compared to a range of 4.3-9.5% for the peer group. Over the medium term (last eight years), the bank’s EPS CAGR growth of 5.0% was below the median peer growth rate of 8.1% and below the range of 4.0-10.0% for the peer group.  CIBC’s profitability on a reported cash basis had been lower than its peer group because of the bank’s large structured finance losses from late 2007 to 2009. Its 2012 ROE was 23% compared to 20% for its peers, but its five-year average ROE of 11% was lower than the 16% median for the group. On a core cash basis (excluding the structured finance- related losses), CIBC’s ROE was 23% compared to 19% for the peer group, and its five- year average ROE was 22% compared to 19%.  Dividend growth in the last 10 years has been below its peers with a median annual growth rate of 4% compared to a range of 7–13% for its peers. CIBC’s five-year, cumulative payout ratio of 51% of core cash earnings is modestly higher than the average of peers, but its reported cash earnings payout of 96% compares to about 57% for peers. Like all Canadian banks, CIBC has been committed to its dividend as it has not cut its quarterly dividend since the 1940s despite periods of high payout ratios.  Capital ratios have been higher than most peers recently. The bank’s Basel III common equity Tier 1 ratio of 9.3% compares to a group range of 8.6–9.6%. CIBC’s assets-to- capital multiple of 18.1x is above the high end of the peer group range of 16.2–18.0x although our estimated Basel III Tier 1 leverage ratio of 3.7% is near the middle of the peer group, which ranges from 3.4% to 4.3%.

National Bank of Canada Description National Bank is the smallest of the Big Six Canadian banks by market capitalization ($14 billion) and by assets ($187 billion). Our 2013 estimated earnings contribution is split among personal and commercial (49%), wealth management (15%), and financial markets (36%). Mortgages account for 47% of loans and acceptances, 16% are consumer loans (including credit card balances), and the remaining 37% are corporate and government loans.

The bank derives 65% of revenues in Quebec, about 30% from other Canadian provinces, and 5% from international sources. In Canada, National Bank is a player in most retail and wholesale businesses, but its retail banking distribution is primarily based in Quebec, Ontario, and surrounding regions. It is the largest Quebec-based bank (Desjardins, a credit union, has a larger asset base at $205 billion).

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History In 1859, Banque Nationale was formed in Quebec City, and after several mergers and acquisitions, including the merger of Banque Canadienne Nationale and The Provincial Bank, National Bank of Canada was formed in 1979. A large part of the bank’s operations were in Quebec, but the bank had been actively developing business on a national scale. In 1985, it acquired The Mercantile Bank of Canada, which helped expand its operations in commercial lending and into Ontario and Western Canada. The bank completed more acquisitions in sectors such as securities brokerage (Lévesque Beaubien in 1988 and First Marathon in 1999) and mutual funds (Altamira in 2002), which helped the bank grow its capabilities and presence in Canada.

National Bank recently made some wealth management acquisitions including HSBC Canada’s full-service retail advisory business for a purchase price of $109 million in 2012, and the remaining 82% of Wellington West Holding Inc. shares that it did not own in 2011 for a purchase price of $273 million, implying a total firm value of $333 million. Recently, National Bank announced the purchase of TD Waterhouse’s Institutional Services business for $250 million. The bank also made a number of small acquisitions or investments in the prior five years including Credigy Ltd. (a purchaser and service provider of US-based distressed consumer receivables) and four small investment management firms for a total of about $170 million.

President and CEO Louis Vachon has been in his current position since June 2007. Prior to that, he was Chief Operating Officer and was Chairman of the Board of National Bank Financial Group and of Natcan Investment Management. He also served as CEO of National Bank Financial. Mr. Vachon became President and CEO of Innocap Investment Management in 1996, and a year later, he was appointed Senior Vice-President of National Bank of Treasury and Financial Markets. Metrics  National Bank’s market share generally ranks number six in most retail and wholesale products in Canada, but it has leading positions among the banks in Quebec. (Desjardins, a group of credit unions, has a leading share of Quebec retail financial services).  As of 2012, the bank’s core cash EPS four-year compound annual growth rate (CAGR) of 9.5% was above the median of 6.2% and compared to a range of 4.1–8.2% for the peer group. Over the medium term (last eight years), the bank’s EPS CAGR of 9.7% was above the median peer growth rate of 8.1% and compared to the range of 4.0-10.0% for the peer group.  National Bank’s profitability has generally been above the peer group in the last five years. Its 2012 ROE was 25% compared to 20% for its peers, and its five-year average ROE of 19% was above the peer average ROE of 16%. On a core cash basis, National Bank’s 2012 ROE was 21% compared to 19% for its peers, and its five-year average ROE of 20%, marginally above the peer average ROE of 19%.  Dividend growth in the last 10 years has been above its peers (median annual growth rate of 13% compared to a range of 4–12% for its peers). Its five-year cumulative payout ratio of 40% is the lowest of its peers (Bank of Montreal’s 57% is highest, and the cumulative payout for peers is 47%). From a historical perspective, National Bank was the only Big Six Canadian bank to cut dividends since the 1940s, doing so in the early 1980s and again in the 1990s.  Capital ratios and leverage have not been as strong as peers recently. The bank’s Basel III common equity Tier 1 ratio of 8.6% is below the peer group range of 8.9–9.6%. National Bank’s assets-to-capital multiple of 18.0x is at the high end of the peer group (ranging from 16.2x to 18.1x), and our estimated Basel III Tier 1 leverage ratio of 3.4% is the lowest of the peer group which range from 3.7–4.7%. September 18, 2013 13 Canadian Bank Primer, Sixth Edition

Royal Bank of Canada Description Royal Bank is Canada’s largest bank by assets ($868 billion) and market capitalization ($96 billion). It has 1,250 domestic branches and another 118 branches mostly in the Caribbean. In 2012, domestic banking contributed about 54% of the total bank’s earnings, wealth management 10%, insurance 10%, investor and treasury services 4%, and capital markets 22%.

The bank is diversified by product and by geography. In Canada, Royal Bank has a number one or two market share position in many retail and wholesale businesses. Internationally, the bank has wealth management and capital markets businesses, as well as Caribbean banking operations. In 2011, the bank sold its Southeast US retail banking franchise to PNC Financial Services Group Inc. as well as its US life insurance company. The bank typically derives about two-thirds of earnings from its Canadian operations.

History The Merchants Bank was founded in Halifax in 1864 and obtained a federal charter five years later. During the next few decades, it expanded first in the eastern provinces of Canada, then opened branches in the western provinces and also established an office in Bermuda in 1882. The expansion led to a change in the name to The Royal Bank of Canada in 1901, and its head office moved to Montreal in 1907. The bank continued to expand nationally and globally, and it was operating in more than 50 countries by the early 1980s. Expansion into more diverse products was accelerated by acquisitions in the late 1980s and 1990s including Dominion Securities, Voyageur Insurance Company, and Royal Trust.

More recently, Royal Bank purchased Ally Credit Canada and ResMor Trust Company in February 2013 for $3.7 billion. In 2012, Royal Bank acquired the other 50% of the RBC Dexia custody joint venture that it did not own from its partner, Banque Internationale à Luxembourg S. A. (formerly Dexia Banque Internationale) for total consideration of €837.5 million or $1.1 billion. It also sold its Southeast retail banking franchise to PNC Financial Services Group Inc. for US$3.45 billion (the bank had invested more than US$6 billion in US banking acquisitions from 2001 to 2008).

From 2008 to 2011, Royal Bank also purchased UK-based Blue Bay Asset Management for $1.6 billion, RBTT (Caribbean banking) for $2.3 billion, and Canadian asset manager Phillips Hager & North for $1.3 billion. The bank also made a number of smaller acquisitions and hired teams of people in wealth management and capital markets globally.

President and CEO Gord Nixon has been in his current position since August 2001 and has worked at the firm since 1979 in a number of operating positions in RBC Dominion Securities Inc. including CEO from December 1999 to April 2001.

Metrics  Royal Bank’s domestic market share generally ranks number one or two in most retail products, and the bank also generally ranks number one or two in capital markets league tables.  As of 2012, the bank’s core cash EPS four-year compound annual growth rate (CAGR) of 4.2% was below the median of 6.2% and compared to a range of 4.1-9.5% for the peer group. Over the medium term (last eight years), the bank’s EPS CAGR growth of 10.0% was above the median peer growth rate of 8.1% and compared to the range of 4.0-9.7% for the peer group.

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 Royal Bank’s reported profitability has been higher than its peer group in the last five years. Its 2012 ROE was 20%, in line with its peers, and its five-year cumulative ROE of 18% compared to 16% for the group. On a core cash basis, Royal Bank’s ROE was 20% compared to 19% for its peers, and compares to a five-year cumulative ROE of 20% compared to 19% for the group.  Dividend growth in the last 10 years has been in line with its peers (median annual growth rate of 12% compared to a range of 4–13% for its peers). Its five-year, cumulative payout ratio of 47% is in line with its peers. Royal Bank’s payout ratio of 50% in 2010 and 47% in 2011 were near the high end of its target payout range of 40–50%.  Capital ratios have been at the high end of its peers’ recently. The bank’s reported Basel III common equity Tier 1 ratio of 9.2% compares to a peer range of 8.6–9.6%. Royal Bank’s assets-to-capital multiple of 16.8x is near the lower end of the group (ranging from 16.2 to 18.1x).

TD Bank Description TD Bank Financial Group is Canada’s second-largest bank by market capitalization ($84 billion) and by assets ($835 billion). TD currently has approximately 1,169 retail branches in Canada and 1,341 branches in the US. Our estimated 2013 earnings mix is as follows: Canadian Personal & Commercial (47%); US Personal & Commercial (22%); Wealth Management & Insurance (20%, which includes 3% for TD Ameritrade); and TD Securities (11%).

TD Bank has the largest Canadian-US retail banking franchise among the Canadian banks with more branches in the US than in Canada. TD also has small wealth and capital markets operations in Europe and Asia. The revenue mix is generally 60–65% Canada, 25–30% US, and 10% in other international countries. In Canada, TD Bank is a leader in many retail products and is known for its customer service and convenience (including the longest open branch hours). In the US, the bank operates mainly in the northeast region and Florida and is also recognized for customer service.

History TD’s earliest predecessor, The Bank of Toronto, was founded in 1855 in Toronto, primarily serving the grain industry with banking, insurance, and commodity exchange services. Separately, in 1867, The Dominion Bank was created by a group of financiers and was given a federal charter in 1869. During the next few decades, both banks grew across Central Canada, then nationally and internationally before merging in 1954. Before the turn of the century, the bank made more acquisitions that diversified its revenue base including Central Guaranty Trust in 1992, Waterhouse Investor Services in 1996, and Newcrest Capital and Canada Trust in 2000.

Since 2005, TD has invested more than $21 billion to build a US retail banking presence. The most recent US deals include the acquisition of Target’s credit card portfolio, Chrysler Financial, an FDIC-assisted acquisition of Riverside National Bank in Florida, and the non-FDIC assisted acquisition of The South Financial Group with branches in North and South Carolina and Florida. Returns on the bank acquisitions have been low (albeit positive) in a difficult operating environment, with income from US banking operations at $1.5 billion in the 12 months ended in the second quarter of 2013, or a return on allocated equity of about 8%. TD also purchased Waterhouse Investor Services in 1996 for $525 million, an acquisition that has proved very successful. Today, TD owns over 45% of TD Ameritrade, a stake that is worth about $2.1 billion.

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President and CEO Ed Clark has been in his current position since December 2002 and has worked at the bank since 1991, when he joined Canada Trust, which TD acquired in February 2000. He was President and Chief Operating Officer from July 2000 until December 2002. In November 2014, Ed Clark will be stepping down as CEO and Bharat Masrani, Chief Operating Officer of TD Bank Group, will be assuming the CEO position of TD Bank Group.

Metrics  TD’s domestic market share generally ranks number one or two in most retail products. The exception had been in small business lending where the bank was below its natural share, but the bank’s share has improved in recent years to within the top three. In wholesale businesses, the bank generally ranks in the top three or four in league tables.  As of 2012, the bank’s core cash EPS four-year compound annual growth rate (CAGR) of 8.2% was above the median of 6.2% and above the range of 4.1–9.5% for the peer group. Over the medium term (last eight years), the bank’s EPS CAGR growth of 9.4% was above the median peer growth rate of 8.1% and above the range of 4.0-10.0% for the peer group.  TD’s profitability has been lower than its peer group in the last five years as the goodwill related to US acquisitions has been a drag on the bank’s ROE. Its 2012 ROE was 15% compared to 20% for its peers, and its five-year average ROE is 14% compared to 16% for the group. On a core cash basis, TD’s ROE was 16% compared to 19% for its peers, and its five-year average ROE is 15% compared to 19% for the group.  Dividend growth in the last 10 years has been in line with its peers (median annual growth rate of 12% compared to a range of 4–13% for its peers). Its five-year cumulative payout ratio of 41% of core cash earnings is at the low end of its peers (the cumulative payout for peers ranges from 40% at National Bank to 57% at Bank of Montreal). TD’s payout ratio of 39% in 2012 was below its target payout range of 40-50%.  Capital ratios are in line with its peers’ recently. The bank’s Basel III common equity Tier 1 ratio of 8.9% compares to the group range of 8.6–9.6%. TD’s assets-to-regulatory- capital multiple of 17.7x is in line with the peer group (ranging from 16.2x to 18.1x), and our estimated Basel III Tier 1 leverage ratio of 3.9% compares to a peer group range of 3.4–4.3%.

Canadian Western Bank Description Canadian Western Bank is the seventh-largest bank in Canada by market capitalization ($2.4 billion) and by asset size ($18 billion) it is the smallest of the eight publicly traded banks. The majority of its assets and earnings are from Western provinces.

The Edmonton-based bank derives over 80% of its revenues from net interest income, and over 80% of its loan portfolio is focused on commercial lending including equipment financing and construction, and another 15% in residential development. It has 41 branches, approximately 2,000 employees, and provides its retail customers with a range of banking, trust, wealth, and insurance products and services.

History Canadian Western Bank was the amalgamation of two banks in 1988: Western & Pacific Bank, established in 1982, and Bank of Alberta, established in 1984. During the next two decades, a number of trust acquisitions were made including the Western Canadian branches of Metropolitan Trust in 1993, North West Trust Company in 1994, and Aetna Trust Company in 1995.

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In the past decade, the bank made several acquisitions to diversify its revenue base including Valiant Trust Company in 2004, Canadian Direct Insurance in 2004, a 73% stake of Adroit Investment Management in 2008, and Winnipeg-based National Leasing Group in February 2010.

Chris H. Fowler has been the bank’s President and Chief Executive Officer since March 2013 and its President since August 2012. Mr. Fowler served as an Executive Vice President at Canadian Western Bank since March 2008 and served as its Chief Operating Officer from December 2011 to March 2013.

Metrics  Canadian Western Bank is primarily a commercial lender in Alberta and British Columbia. It does not have as strong of a consumer banking franchise, it has a small wealth management operation in Alberta, and it does not have wholesale operations. Given its loan exposure in Alberta and British Columbia (combined 80% of the total loan book), some investors qualitatively view Canadian Western Bank’s stock as an indirect play on commodities such as oil.  As of 2012, the bank’s core cash EPS four-year CAGR of 9.6% was above the 6.2% median for the big-six bank peer group, while its medium term (eight-year) CAGR of 16.2% was also well above the 8.1% median growth rate for its peers and compared to a range of 4.0-10.0% for its big bank peers.  Canadian Western Bank’s profitability improved recently relative to peers. Its 2012 ROE was 16% compared to 20% for its big bank peers. The five-year average ROE of 16% was in line with the peer group median. On a core cash basis, the bank’s ROE of 14% compared to 19% for the big bank peers, and its five-year average ROE of 15% compares to 19% for the group.  Dividend growth in the last 10 years has been higher than its peers (median annual growth rate of 23% compared to a range of 4–13% for peers). Its five-year, cumulative payout ratio of 25% is lowest of its peers (the cumulative payout was 47% for the Big Six banks and 34% for Laurentian Bank). Recently, Canadian Western Bank’s payout ratio of 27% in 2012 was in line with its last stated target payout range of 25–30% (the lowest targeted range of the group).  Capital ratios have been lower than its peers recently but leverage ratios are better. The bank’s Basel III common equity Tier 1 ratio of 7.8% is at the low end the group range of 7.5–9.6%. Canadian Western Bank’s assets-to-capital multiple of 8.0x, however, is below the peer group (ranging from 16.2–18.1x).

Laurentian Bank Description The majority of Laurentian Bank’s assets and earnings come from Quebec. Its market capitalization of under $1.3 billion is smallest of the eight banks, and it has assets of $34 billion.

The bank provides a range of retail banking and brokerage services to customers through the third-largest branch network in Quebec (behind Desjardins and National Bank) and has approximately 4,300 employees, of which 60% are unionized. The bank has 40% of loans originated outside Quebec. Its primary business segments include Retail and SME2 Quebec (about 26% of total earnings), Real Estate and Commercial (39%), B2B Trust (30%), and Laurentian Bank Securities (5%).

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History The Montreal City and District Savings Bank (which eventually became Laurentian Bank of Canada) was founded in 1846 by a group of prominent Montrealers. The bank grew during the next century, and after opening its first branch outside Quebec (an Ottawa branch), the bank’s name changed to Laurentian Bank of Canada in 1987. The following year, it merged with Eaton Trust to establish a presence in many Canadian cities including Toronto, Edmonton, Calgary, and Vancouver. At the turn of the century, the bank made an acquisition that created its B2B Trust subsidiary and also entered into a mutual fund joint venture with Edmond de Rothschild Asset Management (which has subsequently ended).

In late 2011, Laurentian Bank acquired the MRS Companies for $199 million ($149 million of shareholders’ equity plus a $50 million premium), and also acquired AGF Trust in 2012 for $248 million in order to bolster the size of its B2B Trust division, which supports independent financial advisors in Canada.

President and CEO Réjean Robitaille has been in his current position since December 2006. He has worked at the bank for more than 25 years in a number of roles including Chief Operating Officer, and prior to that as Executive Vice President of Retail Financial Services.

Metrics  Laurentian Bank’s market share in Quebec generally ranks in the top three or four in many retail products (usually behind Desjardins and National Bank). The bank does not have large wholesale operations, and its loan portfolio is mostly consumer-related (over 75%).  As of 2012, the bank’s core cash EPS four-year CAGR of 8.2% was above the 6.2% median for the big-six bank peer group, while its medium term (eight-year) CAGR of 13.1% was also well above the 8.1% median growth rate for its peers and compared to a range of 4.0–10.0% for its big bank peers.  Laurentian Bank’s profitability has been lower than its peer group in the last five years. Its 2012 ROE of 12% compares to 20% for its big bank peers, and its five-year average ROE of 11% compares to 16% for peers. On a core cash basis, Laurentian Bank’s ROE was 12% compared to 19% for its big bank peers, and its five-year average ROE of 11% compares to 20% for the group.  Dividend growth in the past decade has been the lowest of its peers (median annual growth rate of 2% compared to a range of 4–23% for its peers). Its five-year, cumulative payout ratio of 34% is below the big bank peers (47%) but above Canadian Western Bank’s 25%. Its recent payout ratio of 37% in 2012 was below its target payout range of 40–50%. The bank has generally increased its quarterly dividend every two quarters since 2010.  Capital ratios have been at the low end of its peers recently. The bank’s Basel III common equity Tier 1 ratio of 7.5% compares to a peer range of 7.8–9.6%. Laurentian Bank’s assets-to-regulatory-capital multiple of 17.2x is near the high end of the big bank peer group (ranging from 16.2x to 18.1x).

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SECTION 2: Income statements, balance sheets, and capital In this section, we provide a basic overview of how banks make money by going over major income statement items, such as net interest income and non-interest income, operating expenses, provisions for credit losses, and taxes. We also provide a brief overview of the leverage banks employ and how they are subject to capital requirements. Lastly, we detail the key ratios to look at (and our outlook) when measuring profitability, including net interest income margins, the efficiency ratio, return on assets (ROA), fee income to total income, and return on equity (ROE). How banks make money: A simplified income statement Canadian banks’ income statements can be simplified to five main line items. (Exhibit 1)

Canadian banks derive revenues by generating:

 Net interest income by lending money at a higher rate than borrowed. Net interest income is the net difference between interest earned on assets, such as loans and fixed- income securities, less interest paid on liabilities, such as deposits. Net interest income has represented about half of total revenues in the past decade. It increased recently to about 55% partly as Canadian banks’ adoption of IFRS brought securitized mortgages back on balance sheets in 2012, to the benefit of net interest income and detriment of non-interest income.  Non-interest income from activities such as trading, advisory, account and transaction fees, investment management, insurance, securities gains, and securitizations. Non- interest income has represented about half of total revenues in the past decade. Approximately 30–35% of non-interest revenues are from wealth management businesses (investment management and brokerage fees), 25–30% from capital markets (trading, underwriting, and advisory), and the rest comes from other businesses including retail banking fees and insurance.  Growth in revenues has been approximately 6% per year in the last decade, composed of approximately 6% growth in net interest income and 5% in non-interest income. We expect revenue growth of about 4% in 2013 and 5% in 2014.

Operating or non-interest expenses (NIE) mostly consist of compensation costs, but infrastructure costs, such as premises, information technology, and communications, are important components. Operating expenses typically account for 60% of revenues, versus 65–70% in the early 2000s.

Credit losses on loan portfolios vary, typically based on the strength of the economy. Provisions for credit losses (PCL) for the Canadian banking industry represented about 3% of revenues from 2004 to 2007, about 9–14% when the economy deteriorated in 2008 and 2009, and 6% in recent quarters. PCLs represented 10–15% of revenues in 2001 to 2002, 26% of revenues in 1992, and were as high as 55% in 1987. Even the best banks are hurt by a slower economy, and even the worst are helped by a good economy. We expect credit losses to continue to be low relative to revenues in 2013 and 2014.

Tax rates are generally low, a result of generating revenues from low-tax sources (dividends, for example) as well as from lower-tax jurisdictions. In the past decade, the effective tax rate for the Big Six banks declined to the 19–25% range (or 25–28% for the regional banks) from the mid-30% range. Our financial forecasts for the Canadian banks assume tax rates that are generally below corporate tax rates in developed markets, consistent with what the companies have achieved for some time. We believe that there is more risk than normal to those assumptions in the medium term as governments in many September 18, 2013 19 Canadian Bank Primer, Sixth Edition

countries are keen to reduce deficits/debt loads and might become less tolerant of some currently accepted tax practices. Corporate tax rates are a potential source of revenue, although governments will likely weigh the potential negative impact on employment before simply raising tax rates across the board. We also believe that financial services regulators worldwide will also push for capital to be held in the jurisdictions in which the companies operate, which might reduce the effectiveness of some tax-planning strategies.

Exhibit 1: Annual revenue growth has been 5-6%

Income Statement 11 year History Total Schedule 1 Domestic Banks * CAGR (to 2012) $ millions 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD Q2/13 5-year 10-year

Net Interest Income $ 31,442 $ 31,272 $ 31,694 $ 31,155 $ 31,139 $ 33,330 $ 38,970 $ 45,507 $ 47,224 $ 50,091 $ 58,323 $ 30,173 11.8% 6.4% Non-interest Income 28,946 29,872 31,874 35,253 39,716 40,470 27,213 38,758 42,291 46,303 47,944 24,923 3.4% 5.2% Total Revenue 60,388 61,145 63,567 66,408 70,854 73,801 66,183 84,265 89,515 96,394 106,267 55,096 7.6% 5.8% Non Interest Expenses (NIE) 41,931 41,718 43,110 46,837 44,119 46,419 47,191 53,717 53,627 57,612 61,919 32,267 5.9% 4.0% Provision for credit losses (PCL) 8,909 3,728 1,263 1,921 2,132 3,073 5,902 11,650 7,377 5,769 7,017 3,239 18.0% (2.4)% Net income before taxes (NIBT) ** 9,548 15,699 19,195 17,650 24,604 24,309 13,089 18,899 28,511 33,012 37,330 19,590 9.0% 14.6% Provision for Taxes 1,992 3,856 5,060 4,889 4,904 4,236 631 3,979 7,312 6,973 6,968 3,976 10.5% 13.3% Non-controlling Interests *** 493 597 577 443 462 528 189 480 475 438 588 316 2.2% 1.8% Net Income $ 7,064 $ 11,246 $ 13,557 $ 12,317 $ 19,238 $ 19,545 $ 12,269 $ 14,440 $ 20,724 $ 25,601 $ 29,775 $ 15,298 8.8% 15.5% Median (to 2012) 5-year 10-year Net Interest Income % of Revenue 52% 51% 50% 47% 44% 45% 59% 54% 53% 52% 55% 55% 54% 52% Non-interest Income % of Revenue 48% 49% 50% 53% 56% 55% 41% 46% 47% 48% 45% 45% 46% 48% Return on equity 10% 15% 17% 14% 19% 17% 11% 11% 16% 17% 18% 17% 16% 16% NIE % of Revenue 69% 68% 68% 71% 62% 63% 71% 64% 60% 60% 58% 59% 60% 63% PCL % of Revenue 15% 6% 2% 3% 3% 4% 9% 14% 8% 6% 7% 6% 8% 6% Taxes % of NIBT 21% 25% 26% 28% 20% 17% 5% 21% 26% 21% 19% 20% 21% 21%

Data up to 2011 under Canadian GAAP, and under IFRS starting in 2012. * Schedule 1 banks are domestic banks authorized under the Bank Act to accept deposits, including Bank of Montreal, Scotiabank, CIBC, National Bank, Royal Bank of Canada, TD Bank, Canadian Western Bank, and Laurentian Bank, among others. Schedule 2 banks are foreign-bank subsidiaries, and Schedule 3 banks are foreign-bank branches, which together make up about 6% of total bank assets in Canada. ** Net income before taxes and non-controlling interest in subsidiaries. *** Net of taxes. Source: OSFI, RBC Capital Markets

Leverage is high, but banks must meet capital requirements It is important to analyze banks’ income statements, but analyzing bank balance sheets, capital positions, and capital needs is also crucial.

Canadian bank balance sheets are highly levered, with assets representing about 20x equity. ROA is low (ranging between 0.5% and 0.9% since 2000), but high leverage allows the banks to earn high returns on equity. Banks have always been highly levered institutions, reflecting the low-risk nature of most of their assets and usually stable source of deposits. Balance sheet leverage has come down since the mid-1980s, when leverage was 28–37x (or common equity-to-assets was as low as 2.7–3.5%) during the prior 15 years.

The three main categories of assets are loans, securities, and derivatives.

 Loans represent 52% of assets (Exhibit 2). Loans can be made to individuals (mortgages, personal loans, and credit cards) as well as businesses of all sizes. In the last 25 years, annual growth has averaged 8% in mortgages, 8% in personal lending, and 4% in business lending, with growth in business loans being the most volatile (Exhibit 3).  Securities account for about 20% of assets. They include debt and equity securities and are generally held on balance sheet to support capital markets businesses and treasury operations. Securities are generally more liquid than loans.

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 Derivatives3 represent 7% of assets for banks, although their “net” importance is lower. Derivatives can be used to hedge risks or used in trading businesses. In trading businesses, banks mostly put derivatives on their books as intermediaries (and hedge their risk), or if the trade is proprietary, it is often a long-short trade where the size of the derivative asset is offset by a similarly sized derivative liability.  The asset mix has changed with time, although it has been stable in the last 10 years. Loans represented more than 70% of total assets 25 years ago, while securities made up less than 10% of assets.

Exhibit 2: Loans are the largest asset on banks’ balance sheets

Balance sheet history CAGR (to 2012) Total Schedule 1 Domestic Banks * ($ billions) 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Q2/13 5-year 10-year

Securities $ 426 $ 469 $ 497 $ 569 $ 684 $ 665 $ 635 $ 699 $ 744 $ 773 $ 720 $ 747 1.6% 5.4% Loans 828 814 869 947 1,057 1,184 1,233 1,216 1,290 1,396 1,840 1,901 9.2% 8.3% Reverse repurchase agreements 140 120 140 157 209 240 179 169 236 249 315 377 5.6% 8.5% Derivatives 146 150 157 148 153 194 375 255 273 295 270 265 6.8% 6.4% Other assets 223 218 235 231 285 313 320 284 334 362 384 384 4.1% 5.6% Total Assets $ 1,762 $ 1,770 $ 1,897 $ 2,052 $ 2,388 $ 2,596 $ 2,743 $ 2,623 $ 2,876 $ 3,075 $ 3,529 $ 3,674 6.3% 7.2%

Deposits $ 1,172 $ 1,167 $ 1,231 $ 1,366 $ 1,571 $ 1,713 $ 1,768 $ 1,723 $ 1,854 $ 2,025 $ 2,306 $ 2,408 6.1% 7.0% Repurchase agreement obligations 124 118 118 135 187 188 166 185 195 185 223 244 3.4% 6.0% Derivatives 149 149 159 151 157 193 350 242 279 298 282 272 7.9% 6.6% Other liabilities and non-controlling interests 210 225 277 275 335 347 287 291 314 349 485 515 6.9% 8.7% Subordinated debt 26 26 27 28 31 33 39 37 37 39 42 37 4.9% 5.1% Preferred shares 10 9 4 6 7 9 13 19 20 20 18 18 15.2% 6.5% Common equity (incl. retained earnings) 72 75 80 91 101 113 120 126 144 158 173 181 8.9% 9.2% Total Liabilities & Shareholders' Equity $ 1,762 $ 1,770 $ 1,897 $ 2,052 $ 2,388 $ 2,596 $ 2,743 $ 2,623 $ 2,843 $ 3,075 $ 3,529 $ 3,674 6.3% 7.2% Median 5-year 10-year Tangible common equity $ 54 $ 60 $ 66 $ 77 $ 83 $ 95 $ 88 $ 95 $ 114 $ 125 $ 142 $ 146 Tangible common equity / Common equity 75% 80% 83% 84% 83% 84% 74% 76% 79% 79% 82% 81% 79% 81% Common equity / Assets 4.1% 4.2% 4.2% 4.4% 4.2% 4.4% 4.4% 4.8% 5.0% 5.2% 4.9% 4.9% 4.9% 4.4% Loans / Assets 47% 46% 46% 46% 44% 46% 45% 46% 45% 45% 52% 52% 45% 46% Securities / Assets 24% 26% 26% 28% 29% 26% 23% 27% 26% 25% 20% 20% 25% 26% Derivatives / Assets 8% 8% 8% 7% 6% 7% 14% 10% 9% 10% 8% 7% 10% 8% Deposits / Assets 67% 66% 65% 67% 66% 66% 64% 66% 64% 66% 65% 66% 65% 66% Common equity / Total capital 67% 69% 72% 73% 73% 73% 70% 69% 72% 73% 74% 77% 72% 72% Preferred equity / Total capital 9% 8% 4% 5% 5% 6% 7% 11% 10% 9% 8% 8% 9% 8% Subordinated debt / Total capital 24% 24% 24% 23% 22% 21% 23% 20% 18% 18% 18% 16% 18% 22% Common equity / Shareholders' equity 88% 90% 95% 94% 94% 93% 90% 87% 88% 89% 90% 91% 89% 90%

As of April 30, 2013. Data up to 2011 under Canadian GAAP, and under IFRS starting in 2012. * Schedule 1 banks are domestic banks authorized under the Bank Act to accept deposits, which together make up about 94% of total bank assets in Canada. Source: OSFI, RBC Capital Markets

3 A derivative is a contract between two parties that requires little or no initial investment and where payments between the parties depend on the price movements of an underlying instrument, index, or financial rate. Examples of derivatives include swaps, options, forward rate agreements, and futures. The notional amount of the derivative is the contract amount used as a reference point to calculate the payments to be exchanged between the two parties, and the notional amount itself is generally not exchanged by the parties. September 18, 2013 21 Canadian Bank Primer, Sixth Edition

Exhibit 3: Loan growth has historically been lower and more volatile in business lending

Canadian Loan Growth (YoY) (Since 1972)

40% 25-year Average Most Recent Loan Loan Growth: Growth:

30% Consumer: 8.0% Consumer: 2.2% Mortgages: 8.1% Mortgages: 4.9% Commercial: 3.6% Commercial: 12.1% 20%

10%

-10%

-20% 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Consumer Res. Mortgages Commercial

As of June 2013 for consumer and mortgages and July 2013 for Commercial. Includes all chartered Canadian banks. Source: Statistics Canada, RBC Economics, RBC Capital Markets

By far the biggest liability for banks is deposits, which fund about 66% of assets. Banks source deposits from retail clients, commercial and corporate clients, institutional clients, and governments. We estimate that “core” deposits, i.e., retail and small-business deposits, account for 59% of total deposits. A good portion of securities and derivatives is funded by short-term borrowings, securities sold short, derivative liabilities, assets sold under repurchase agreements, and securities loaned.

Banks need to hold capital in order to guard against the risks inherent in their businesses, including credit risk, operational risk, market risk, and liquidity risk. Capital is required for both expected and unexpected risks, and we consider it to be the “second line of defence” against the cost of unexpected risks, with the “first line” being income generation.

 Capital is made up of common equity, equity-like instruments, and debentures. Common equity historically made up about 72% of capital (it has increased to 77% more recently due to the transition to Basel III), preferred shares about 9%, and debt 22%.  The appropriate level of capital is not only a function of assets on the balance sheet but also a function of the risk of those assets, as well as risks not measured on balance sheets, such as guarantees, contingent liabilities, and operational risk. Net income stability and diversity are also an important consideration when thinking of appropriate capital levels.  Many constituents influence capital levels, including regulators, rating agencies, managements, and boards of directors, as well as debt and equity investors. Protecting depositors is also fundamental to a bank’s operations and capital position.  Banks manage their capital structures from two main perspectives: regulatory capital and economic capital. Capital management is a balancing act of maintaining capital levels that satisfy regulators, capital markets participants, and rating agencies, while also generating attractive returns for shareholders.  We review capital requirements and expected changes in detail in “SECTION 8: Capital supports both expected and unexpected risks”. September 18, 2013 22 Canadian Bank Primer, Sixth Edition

Higher leverage can contribute to a higher ROE, but the variability of ROE for Canadian banks has historically been more a function of variations in margins (return on assets) than leverage (Exhibit 4).

Exhibit 4: ROA and leverage should both drive ROE; we expect lower ROE than 2005-2007 levels in foreseeable future

ROE vs. ROA Return on Equity vs. Leverage (Annual since 1970) (Annual since 1970) Correlation Coefficient: 0.93 Correlation Coefficient: 0.18 30% 1.1% 5.0% 40.0%

35.0% 25% 0.9% 4.5% 30.0% 20% 0.7% 25.0%

15% 0.5% 4.0% 20.0%

10% 0.3% 15.0%

3.5% 10.0% 5% 0.1% 5.0% 0% -0.1% 3.0% 0.0%

-5% -0.3% (5.0%)

2.5% (10.0%) -10% -0.5% 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 Common equity /Assets (LHS) Reported Cash ROE Cash ROE (LHS) Cash ROA (RHS)

As of Q3/13, the median of Big Six Banks (BMO, BNS, CM, NA, RY, and TD). Reported cash ROE and ROA include special items and exclude preferred dividends, goodwill, and intangibles. Source: Company reports, RBC Capital Markets

While ROA has been a more useful predictor of change in ROE than leverage, we do believe banks will operate with similar ROAs but lower leverage than in 2005-2007, when the sector’s peak ROE was 23.5% and ROTE was 29.4%. We are forecasting ROA of 0.80% in 2014 and 0.81% in 2015, compared to ~0.9% in the 2005–2007 period (with the decline in large part from securitized mortgages being brought back on balance sheet) but are expecting leverage to come down as a result of more stringent regulatory capital requirements. We believe that leverage will stabilize at 2014 levels as most banks should have sufficiently built up their capital levels to meet their new regulatory capital targets. Exhibit 5 highlights the change in profitability (measured as return on tangible equity) that we expect will result from lower leverage compared to the 2005–2007 period.

September 18, 2013 23 Canadian Bank Primer, Sixth Edition

Exhibit 5: We expect return on tangible equity to decline on lower leverage

2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E ROTCE (core cash) BMO 20.7% 20.7% 21.7% 16.4% 15.0% 16.5% 17.0% 19.3% 18.0% 17.6% 16.9% BNS 22.2% 23.2% 25.4% 24.5% 20.7% 21.6% 23.6% 22.4% 21.8% 21.6% 20.6% CM 28.5% 30.6% 33.2% 28.0% 23.5% 26.5% 28.1% 27.0% 25.5% 22.3% 21.4% NA 19.3% 19.5% 23.9% 24.9% 25.1% 22.5% 26.5% 29.4% 26.3% 23.4% 21.8% RY 27.1% 29.9% 32.3% 32.4% 29.3% 22.1% 24.7% 25.4% n/a n/a n/a TD 35.3% 36.7% 37.9% 33.9% 27.7% 24.3% 25.2% 24.2% 22.2% 23.3% 22.8% Total 25.6% 26.9% 29.3% 27.0% 23.7% 22.0% 23.7% 23.8% Total ex RY 25.1% 26.0% 28.4% 25.3% 21.8% 22.0% 23.4% 23.2% 21.8% 21.4% 20.7%

ROE (core cash) BMO 18.3% 19.1% 19.4% 15.0% 13.2% 15.1% 16.0% 15.5% 14.8% 14.7% 14.2% BNS 21.1% 22.2% 21.9% 21.3% 17.5% 18.7% 19.4% 17.6% 16.4% 16.1% 15.8% CM 23.8% 27.4% 27.4% 22.6% 19.7% 21.8% 24.8% 22.6% 22.0% 20.0% 19.6% NA 19.2% 19.7% 20.1% 19.1% 19.7% 17.9% 20.9% 20.6% 19.4% 18.1% 17.4% RY 19.8% 23.4% 24.8% 22.8% 20.2% 17.2% 20.4% 19.8% n/a n/a n/a TD 20.5% 18.8% 20.4% 15.8% 12.3% 13.9% 17.3% 16.3% 15.2% 16.4% 16.5% Total 20.5% 21.6% 22.4% 19.3% 16.3% 16.7% 19.2% 18.0% Total ex RY 20.7% 21.1% 21.7% 18.2% 15.0% 16.5% 18.7% 17.5% 16.5% 16.5% 16.2%

ROA (core cash) BMO 0.78% 0.85% 0.78% 0.55% 0.51% 0.68% 0.65% 0.72% 0.72% 0.72% 0.71% BNS 1.04% 1.01% 1.00% 0.86% 0.69% 0.80% 0.81% 0.81% 0.82% 0.84% 0.86% CM 0.81% 0.85% 0.91% 0.74% 0.60% 0.74% 0.76% 0.82% 0.86% 0.83% 0.85% NA 0.85% 0.79% 0.72% 0.68% 0.71% 0.73% 0.71% 0.71% 0.70% 0.70% 0.72% RY 0.84% 0.93% 0.93% 0.86% 0.90% 0.84% 0.85% 0.91% n/a n/a n/a TD 0.85% 0.88% 1.03% 0.86% 0.75% 0.86% 0.88% 0.85% 0.81% 0.83% 0.83% Total 0.86% 0.90% 0.92% 0.78% 0.72% 0.79% 0.80% 0.82% Total ex RY 0.87% 0.89% 0.92% 0.76% 0.65% 0.78% 0.78% 0.80% 0.80% 0.80% 0.81%

Average Assets/Average TCE BMO 26.6x 24.4x 27.9x 29.9x 29.6x 24.2x 26.0x 26.9x 24.9x 24.3x 23.6x BNS 21.4x 22.9x 25.5x 28.6x 30.2x 27.1x 29.2x 27.7x 26.5x 25.7x 23.9x CM 35.3x 36.2x 36.5x 37.9x 38.9x 35.7x 36.9x 33.0x 29.6x 26.8x 25.1x NA 22.6x 24.8x 33.0x 36.8x 35.4x 31.0x 37.3x 41.7x 37.6x 33.3x 30.3x RY 32.4x 32.4x 34.6x 37.7x 32.7x 26.4x 29.0x 28.1x n/a n/a n/a TD 41.4x 41.8x 36.9x 39.3x 36.8x 28.4x 28.6x 28.3x 27.2x 28.0x 27.4x Total 29.7x 29.9x 31.8x 34.4x 33.2x 27.8x 29.6x 28.9x Total ex RY 28.9x 29.1x 30.9x 33.4x 33.4x 28.3x 29.8x 29.1x 27.3x 26.7x 25.5x

Average Assets/Average Common Equity BMO 23.6x 22.6x 24.9x 27.2x 26.0x 22.1x 24.4x 21.6x 20.4x 20.4x 19.9x BNS 20.3x 21.9x 22.0x 24.9x 25.5x 23.4x 24.0x 21.7x 19.9x 19.2x 18.3x CM 29.4x 32.3x 30.1x 30.6x 32.7x 29.4x 32.5x 27.5x 25.5x 24.1x 23.0x NA 22.5x 25.1x 27.8x 28.2x 27.7x 24.6x 29.4x 29.3x 27.8x 25.7x 24.1x RY 23.7x 25.3x 26.5x 26.5x 22.5x 20.6x 23.9x 21.8x n/a n/a n/a TD 24.0x 21.4x 19.9x 18.3x 16.4x 16.2x 19.7x 19.1x 18.6x 19.7x 19.8x Total 23.7x 24.1x 24.3x 24.7x 22.8x 21.0x 23.9x 21.9x Total ex RY 23.8x 23.7x 23.6x 24.1x 22.9x 21.2x 23.9x 21.9x 20.6x 20.5x 20.0x

Source: Company reports, RBC Capital Markets estimates

Banks operate in three main business lines Our income statement and balance sheet discussions look at the banks as consolidated entities, but the Canadian banks are very diversified by product and client type. Business lines are reported differently from bank to bank but are broken down broadly as follows:

 Retail banking operations consist of branch banking and online banking, with products including mortgages, credit cards, term loans, car loans, secured and unsecured lines of credit, transaction accounts, savings accounts, and term deposits. Small business and commercial banking are generally considered to be part of retail banking. Retail banking accounts for 50–70% of income in normal periods and includes non-domestic operations (US banking for TD and Bank of Montreal; Caribbean banking for Royal Bank and CIBC; and Latin America, Caribbean, and Asia for Scotiabank). For three banks (TD Bank, Royal Bank and Bank of Montreal), insurance is also a significant business, but it has yet to be fully integrated into the retail branch network. Despite relentless lobbying, regulators

September 18, 2013 24 Canadian Bank Primer, Sixth Edition

and public policymakers have resisted requests from the banks to offer a full line of insurance products in their bank branches.4  Wholesale banking deals with corporate and institutional clients. Activities include corporate lending, trading businesses, underwriting, and advisory (i.e., M&A). Wholesale businesses account for 15–40% of income in normal periods, depending on the bank. Wholesale divisions contributed more than normal to earnings from early 2009 to early 2010 because trading results were strong and retail divisions were negatively affected by higher loan losses while wealth management revenue contribution declined on lower equity markets and short-term interest rates (which hurt margins). Relative earnings contributions have normalized since then.  Wealth management includes retail brokerage (full service and discount), mutual fund management, trust, and private counselling, as well as, for some banks, fixed-term deposits. Those businesses make up 10–20% of banks’ income in normal periods.  We discuss the three business lines in detail in Sections 4, 5, and 6.

The banks are also geographically diversified and have been for a long time. Non-domestic earnings contributed about 15–30% of total net income in 1990 as well as in recent years. In the past decade, banks have made significant acquisitions outside Canada, particularly TD Bank, Scotiabank, Royal Bank, and Bank of Montreal. Since the TD Canada Trust merger in 2000, Canadian banks have spent about $50 billion on acquisitions outside Canada and $21 billion on domestic acquisitions. Some banks have also made divestitures during the years. Larger sales include Royal Bank’s recent sale of its US retail banking franchise for US$3.6 billion as well as the sale of its US life insurance company for US$0.6 billion in 2010; CIBC’s sale of its US investment banking business to Oppenheimer & Co. in 2007; and Bank of Montreal’s sale of CSFB Direct to E*Trade in 2006 (after having bought it in 2002). Key measures of consolidated profitability to track Now that we have summarized how banks make money, what is on their balance sheets, how they must meet capital requirements, and what business lines they are in, we provide an overview of the important profitability ratios to track when analyzing banks. We review the important measures for credit, capital, and valuation later in the relevant sections of this primer (Section 7 for credit, Section 8 for capital, and Section 9 for valuation).

Net interest income margins measure how much net interest income is generated from a bank’s asset base. It is the difference between interest income (loan or asset yield) and funding expenses (mostly deposit expenses) divided by assets. A higher net interest income margin is preferred, unless it is achieved by taking meaningful incremental risk (riskier assets normally generate higher yields). Overall, bank margins are lower today (1.9%) than a decade ago (2.3%), reflecting the lower credit risk of assets (which are increasingly made up of mortgages), the increased proportion of funding that is wholesale compared to retail, and lower interest rates. Margins in retail businesses have declined over the past decade, to 2.5% from 3.5%, because loans have become increasingly secured, funding costs have risen as banks’ retail loans are no longer fully funded by retail deposits (see Section 4 on Retail Banking for reasons), and low interest rates (including yields on five-year assets) have negatively affected the profitability of zero-cost deposits.

 We forecast margin pressure to abate in 2014 based on current interest rates, and margin improvement in 2015 is likely if there are further increases in short- and

4 Banks are allowed to sell only certain insurance products in their bank branches, which include creditor life, travel, and mortgage insurance. Banks cannot promote life insurance and/or auto, and home insurance in their branches. These provisions are part of the Bank Act, which is typically reviewed every five years. It was last reviewed in 2012. September 18, 2013 25 Canadian Bank Primer, Sixth Edition

medium-term rates. The recent increase in 5-year bond yields should reduce the margin pressure banks are facing in 2014 and if 5-year yields rise further, it could lead to margin expansion on zero-cost funds in 2015. Furthermore, higher short-term rates, when they occur, should help margins on certain types of deposits such as high yield savings accounts and short-term GICs, while loan mix should improve (greater growth in commercial mortgages than residential mortgages) and growth in loans and deposits should be more balanced as loan growth slows.

Exhibit 6: Net interest margins normally narrow when loan losses decline and the yield curve is flat

Net Interest Margin vs. Loan Loss Provisions as % of Total Loans Net Interest Margin vs. Yield Curve (5yr - 3mo) (Annual Since 1980) (Annual Since 1998) Correlation Coefficient: 0.68 3.5% Correlation Coefficient since 2000 : 0.55 3.1% 2.4% 3.0% 2.5% 2.2% 2.5%

1.9% 2.0% 2.0%

1.3% 1.8% 1.5%

0.7% 1.6% 1.0%

0.1% 1.4% 0.5%

-0.5% 1.2% 0.0% 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Yield Curve: 5yr - 3mo (LHS) NIM (NII/Average Earning Assets) (RHS) NIM (NII/Average Total Assets) (RHS) Total Provisions as % of Loans NIM (NII/Total Assets) NIM (NII/Earning Assets)

Correlation between 5yr Canadian Govt Bond - 3mo. Canadian Govt T-Bill spread and Net interest margins (average earning assets). Annual Yield Curve is the Average of the Daily Yield Curve. Net interest margins and Provisions for Credit Losses are the Average of Big Six banks. Source: Company reports, Bank of Canada, RBC Capital Markets

Net interest income margins can be adjusted for risk by using risk-weighted assets as a denominator instead of assets. This method, in theory, eliminates the net interest income margin discrepancies that come from differences in asset risk. Net interest income margins based on risk-weighted assets have been higher than on an unweighted basis for Canadian banks. Net interest income divided by risk-weighted assets has risen to 4.7% today from 3.3% in 2000, which is an opposite trend versus the margin based on unweighted assets because the growth in risk-weighted assets has been lower than the growth in unweighted assets.

The efficiency ratio is equivalent to a gross-margin calculation (although done backwards). It is defined as operating expenses divided by revenues (so a higher number is a bad thing, all else being equal). This measure is useful when comparing similar business lines or when comparing time series. It is not a useful method when comparing different business lines. As an example, corporate lending is characterized by very low-efficiency ratios (a good thing) but also low ROE given the high capital charges. Wealth management, on the other hand, has high efficiency ratios (a bad thing) given a compensation structure that rewards individual advisors generously given the tightness of their client relationships, but generally high ROE given low capital requirements. Executives and investors alike would generally prefer more wealth revenues despite the generally high-efficiency ratio. Consolidated efficiency ratios have improved in the past 10 years (to about 58% today from 67–68% in 2000), while the ratio in retail businesses has also improved to 49% today from about 62–63%. (Exhibit 7)

 Expenses will likely be affected by many moving parts, and they should not be looked at in isolation: Normal pressure on expense growth (wages, benefits, infrastructure, and information technology,) is likely to continue although the rate of growth should decline as banks spend more time focusing on their expense line in the near term, given a likely slowdown in revenue growth. The biggest swing in expenses is likely to be variable September 18, 2013 26 Canadian Bank Primer, Sixth Edition

compensation, where declines might be interpreted as positive if expenses are looked at in isolation but may in fact be negative for overall profitability because, implicitly, revenues would be down.  Generally, banks are able to generate positive operating leverage (i.e., grow revenues faster than expenses) in environments where revenue growth is 3% or more, and cannot adjust their expenses down fast enough in years in which revenue growth declines. (Exhibit 8)

Exhibit 7: Retail efficiency ratios have improved since 2008

Total Productivity Ratio *

2006 2007 2008 2009 2010 2011 2012 Median Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 BMO 64% 71% 68% 67% 62% 63% 63% 64% 64% 65% 63% 65% 63% BNS 57% 56% 61% 55% 53% 55% 53% 55% 47% 56% 54% 54% 54% CM 65% 63% 194% 67% 58% 60% 57% 64% 58% 58% 62% 58% 57% NA 64% 73% 70% 62% 63% 60% 58% 63% 59% 62% 59% 56% 58% RY1 56% 56% 57% 50% 52% 51% 51% 54% 48% 52% 51% 52% 55% TD 60% 63% 65% 68% 62% 60% 61% 63% 59% 61% 59% 60% 63% Median 62% 63% 66% 64% 60% 60% 58% 63% 59% 60% 59% 57% 58%

Retail Productivity Ratio *

2006 2007 2008 2009 2010 2011 2012 Median Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 BMO 59% 58% 60% 56% 54% 53% 55% 57% 55% 55% 55% 55% 55% BNS 62% 58% 56% 53% 48% 51% 50% 55% 49% 51% 49% 50% 50% CM 60% 56% 58% 52% 51% 50% 50% 54% 50% 51% 49% 50% 49% NA 62% 60% 58% 59% 58% 57% 57% 59% 55% 60% 55% 56% 54% RY 54% 51% 50% 48% 47% 45% 45% 49% 43% 45% 44% 45% 44% TD 55% 52% 51% 50% 48% 47% 47% 51% 46% 49% 45% 48% 45% Median 60% 57% 57% 52% 49% 51% 50% 54% 49% 51% 49% 50% 49%

Wholesale Productivity Ratio *

2006 2007 2008 2009 2010 2011 2012 Median Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 BMO 58% 80% 74% 57% 56% 57% 60% 58% 60% 58% 57% 59% 59% BNS 40% 41% 51% 30% 38% 47% 42% 42% 41% 43% 43% 44% 43% CM 82% 94% -22% 207% 67% 59% 54% 75% 54% 46% 79% 52% 51% NA 58% 56% 64% 46% 50% 53% 54% 55% 52% 59% 52% 46% 44% RY 63% 63% 54% 52% 58% 65% 61% 62% 58% 59% 55% 61% 62% TD 58% 51% 96% 44% 49% 59% 59% 58% 64% 52% 66% 58% 62% Median 58% 60% 59% 49% 53% 58% 57% 58% 56% 55% 56% 55% 55%

* Efficiency ratio is expenses divided by reported revenues including special items. 1) RY's expenses exclude insurance policyholder benefits, claims and acquisition expense, while revenues include insurance premiums, investment and fee income. Source: Company Reports, RBC Capital Markets Research

Exhibit 8: Since 2000, 2005 & 2011 were the only negative operating leverage years when revenue growth was >4%

Aggregate 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E Revenue Growth 15.3% 3.8% (1.2%) (0.4%) 3.8% 6.7% 5.5% 0.9% (14.5%) 30.0% 10.9% 9.9% 9.7% 4.1% 6.0% 4.6% Expense Growth 13.1% 4.9% 4.2% (0.4%) 2.9% (13.7%) 19.7% 3.2% 0.8% 10.3% 1.9% 12.4% 8.1% 5.0% 3.5% 3.0% Operating Leverage 2.3% (1.1%) (5.5%) 0.1% 0.9% 20.5% (14.2%) (2.4%) (15.3%) 19.7% 9.0% (2.5%) 1.6% (0.9%) 2.5% 1.6%

Note: Numbers are shown on a reported basis. Our 2014 forecasts for operating leverage (2.5%), revenue growth (6.0%) and expense growth (3.5%) would be 0.6%, 5.0% and 4.4%, respectively, if excluding (1) one- time fees and integration charges related to the purchase of MBNA Canada and a portion of CIBC’s Aerogold credit card book at TD Bank, (2) integration charges at Bank of Montreal and National Bank in 2013 that we do not expect to recur in 2014, (3) litigation expenses incurred in Q1/13 at CIBC and TD Bank that we are not modelling in 2014, (4) insurance related charges at TD Bank in Q3/13, and (5) one-time gains that CIBC will record upon TD’s purchase of a portion of its Aerogold credit card book in 2014. Source: Company reports, RBC Capital Markets estimates

September 18, 2013 27 Canadian Bank Primer, Sixth Edition

In the near term, changes in capital markets and wealth management revenues have the greatest effect on expenses and the efficiency ratio.

 Wholesale expenses have a good degree of flexibility because significant components are made up of compensation-related costs, much of which are variable. We estimate that 60–70% of total expenses in wholesale divisions represent compensation-related expenses. Expenses typically account for 50–60% of revenue, depending on revenue mix (corporate lending has much lower operating expenses compared to other areas of wholesale banking, for example).  Full-service brokerage costs are high as a percentage of revenues (70–80%) and include technology, compliance, and physical infrastructure, but the biggest factor would be commissions to brokers, which are a variable item. Mutual fund operations also have a significant component of expenses that is variable, particularly related to distribution (trailer fees are paid quarterly to distributors based on asset values).  Tracking operating efficiency is important, but we would focus on trends in each bank rather than comparing absolute numbers among banks because operating efficiency is heavily influenced by business mix and does not consider capital requirements or risk.

Provisions for credit losses can have a meaningful effect on net income. The PCL ratio measures provisions as a percentage of the size of a bank’s loan book. Banks and analysts often refer to “normal” loan loss rates as a tool to forecast earnings, which we find misleading. We would observe that loan losses are either above-average during and following an economic slowdown, or below average during periods of economic growth. We forecast the PCL ratio to be better than “normal” in 2014 and 2015 (Exhibit 9). We provide more detail on credit in “Section 7: Loan losses can be material, but exposure has declined”.

Exhibit 9: We expect provisions for credit losses to be better than “normal” in 2014/2015

Provisions for Credit Losses by Product (Annual since 1990)

3.0% Average PCLs (since 1990): Residential Mortgages: 0.03% 2.5% Consumer Loans: 1.06% Business and Government Loans: 0.73% 2.0% Total Loans: 0.58%

1.5%

1.0%

0.5%

0.0%

-0.5% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E

Total Loans* Consumer Loans *based on total PCLs Residential Mortgage Business & Gov't

Source: Company reports, RBC Capital Markets estimates

Tax rates need to be tracked as they can have material impact on the bottom line, especially on a quarterly basis. Canadian bank tax rates have declined in the last 15 years, in part driven by declining corporate tax rates in Canada, contributing to bottom line growth. Our financial forecasts for the Canadian banks assume tax rates that are generally below corporate tax rates in developed markets, consistent with what the companies have achieved for some time. We believe that there is more risk than normal to those assumptions in the medium term as governments in many countries are keen to reduce September 18, 2013 28 Canadian Bank Primer, Sixth Edition

deficits/debt loads and might become less tolerant of some currently accepted tax practices. Corporate tax rates are a potential source of revenues although governments will likely weigh the potential negative impact on employment before simply raising tax rates across the board. We also believe that financial services regulators worldwide will also push for capital to be held in the jurisdictions in which the companies operate, which might reduce the effectiveness of some tax-planning strategies. The tax rates we are assuming for 2014/2015 are 18-21% for TD Bank, CIBC, Bank of Montreal and Scotiabank and ~27% for National Bank. (Exhibit 10)

Exhibit 10: We are modelling higher tax rates in 2014/2015 than in 2012/2013

Tax Rate BMO BNS CM NA RY TD 2000 33.9% 33.2% 23.2% 31.4% 38.8% 33.8% 2001 24.2% 27.5% 5.0% 29.8% 34.7% 27.0% 2002 22.3% 23.0% -67.7% 30.1% 32.0% 28.9% 2003 26.7% 23.1% 10.9% 30.0% 32.7% 25.1% 2004 29.5% 20.8% 27.3% 30.0% 29.8% 26.0% 2005 26.3% 20.5% 85.1% 25.0% 27.0% 24.7% 2006 21.5% 18.6% 18.7% 23.5% 22.5% 24.4% 2007 7.9% 20.3% 13.6% 20.0% 19.8% 20.1% 2008 -3.6% 17.5% 52.1% 25.0% 22.8% 13.7% 2009 10.4% 23.6% 26.2% 21.7% 28.4% 17.2% 2010 19.2% 28.7% 38.2% 27.9% 25.5% 21.8% 2011 22.0% 21.1% 24.4% 25.8% 21.8% 18.6% 2012 18.3% 19.6% 17.4% 23.4% 21.7% 14.9% 2013E 20.7% 20.8% 16.5% 24.2% N/A 16.8% 2014E 21.3% 20.7% 18.8% 27.2% N/A 20.3% 2015E 21.8% 20.9% 19.0% 27.2% N/A 20.5%

Source: Company reports, RBC Capital Markets estimates

ROA (net income divided by assets) is a measure of net income margins on an unlevered basis. All else being equal, a higher ROA is better; however, it is possible for a bank to boost its ROA by growing in riskier areas with losses unlikely to come for a few years, so a higher ROA is not always better. ROA is low (0.9% in the 2006–2007 period and 0.8% in recent quarters) but was lower historically (0.4–0.5% in the 1970s and 1980s, 0.6–0.8% in the 1990s to 2004). Beginning in 2011, ROA was negatively impacted by the increase in balance sheet size that resulted from the conversion from CGAAP to IFRS, which led to many securitized assets coming back on balance sheets. Since many of these assets were lower risk, the impact on ROA was negative.

 We expect ROAs to remain at current levels of 0.80–0.85% as credit losses are likely to be stable and we do not believe that some lines of business are significantly more or less profitable than usual at this time.

Return on risk-weighted assets or RoRWA (net income divided by risk-weighted assets) is also a measure of net income margins on an unlevered basis. Unlike ROA, it attempts to “equalize” assets based on their risk and would reward firms generating low spreads on low- risk assets. RoRWA had decreased to 1.4% in 2008 and 2009 from about 2.1% in 2006–2007, driven by securities writedowns and increased loan losses, but it has improved in recent quarters to above 2.4% (Exhibit 11). We expect RoRWA to remain stable for the same reason as ROA. September 18, 2013 29 Canadian Bank Primer, Sixth Edition

Exhibit 11: Return on risk-weighted assets has increased since the early 1990s

Return on Risk Weighted Assets (Annual since 1988) 3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0% 88 90 92 94 96 98 00 02 04 06 08 10 12

RORWA (Reported, Cash)

Median of Big Six Banks. Reported cash RoRWA includes special items and excludes preferred dividends, goodwill, and intangibles. RWA is calculated using Basel II from (Q1/08-Q4/12) and Basel III beginning in Q1/13. Source: Company reports, RBC Capital Markets

Fee income to total income is a useful directional indicator of revenue diversification between non-lending and lending areas, although it is not perfect. A higher ratio of fee income implies less traditional credit risk and less balance sheet usage (therefore higher ROE) but also implies greater market risk related to securities portfolios and potentially higher revenue volatility related to volatility in capital markets. New, higher capital requirements for market risk and counterparty credit risk should make the relationship between fee income and ROE less useful.5 Since 1980, non-interest income has risen to about 46%6 of total revenues from about 20% (it was close to 60% before the market disruptions in the second half of 2007) because banks diversified beyond capital-intensive lending businesses and grew low-capital fee sources such as wealth management and some capital markets businesses (Exhibit 12).

 We expect a longer-term trend to continue to favour growth in non-interest revenues over net interest income, with variability driven in large part by periods of stress in capital markets (including lower equity market levels and lower client activity, which can lead to lower wealth management and wholesale revenues), particularly because trading losses and writedowns are netted from non-interest revenues.  We estimate that 40–50% of non-interest income is sensitive to movements in capital markets, particularly equity markets. Non-interest income in 2012 accounted for about 43% of total revenues, down from 59% in 2006. The decline largely reflected lower market-related revenues and the adoption of IFRS, which reduces securitization income and increases net interest income from bringing securitized assets on balance sheet. We forecast non-interest income to make up ~43% of revenues in 2014 and 2015.  We are positive on the medium-term outlook for wealth management businesses driven by improved equity market levels. If equity markets grow at historical rates from current levels (i.e., approximately 8% per year), we would expect annual revenue growth of 6–10% over the medium term in wealth businesses. Revenues are sensitive to

5 New capital requirements increased stated market risk in Q1/12 and capital requirements for counterparty credit risk will also rise in Q1/14. 6 The adoption of IFRS in 2011 led to securitized mortgages being brought back on balance sheets, to the benefit of net interest income and detriment of non-interest income. September 18, 2013 30 Canadian Bank Primer, Sixth Edition

fluctuations in equity markets in the near term, as a large proportion of revenues (asset management, fee based wealth management) are directly based on asset levels, and transactional businesses are also generally positively correlated to equity market direction.  We expect modest growth in wholesale revenues in 2014 and 2015, with the potential for greater revenues in a more buoyant risk-on environment. However, reduced risk appetite by investment dealers (either self-induced or regulatory driven) is not supportive of a potential revenue recovery to peak levels experienced in H2/09. Capital markets divisions typically generate approximately 25-30% of non-interest revenues with about 40% coming from advisory and underwriting, and 60% coming from trading (although contributions can fluctuate significantly).  We believe that growth in net interest income will decline because Canadian consumer debt is unlikely to continue growing more quickly than disposable income, as has been the case for the last decade, and low interest rates are continuing to pressure margins.

ROE is similar to the calculations in other industries (net income divided by shareholders’ equity). Like other industries, it is a function of ROA and leverage. Changes in ROA have historically been more significant to changes in ROE than have fluctuations in leverage (Exhibit 4). Steadily rising ROA have allowed the banks to earn higher ROE, which have risen to around 19% in 2012 and 17% 2013YTD, up from 10–15% in the 1970s to early 1990s.

 ROE peaked at 23% for the Big Six Banks in 2006, which reflected buoyant equity and capital markets, and low loan losses. We believe that “normal” ROE, based on the current business mix, is closer to 16-17%. ROE was 20% in 2011 and 19% in 2012 because loan losses were low, compared to 16% in 2010 when loan losses were high, and 13% in 2009 because of capital markets-related writedowns as well as tough economic and capital markets conditions. So far in 2013, ROE has remained near 18% despite banks’ holding more capital than in the past as provisions for credit losses have stabilized and writedowns have been negligible. We do not expect provisions for credit losses to be a driver of earnings growth in 2014/2015 as key indicators of future loan losses are pointing to stable loan losses in all areas (business, personal, and mortgage lending).  While changes in ROE have historically been more driven by changes in ROA than changes in ROE, the introduction on new capital rules has led to Canadian banks building up their capital levels in recent years, which we expect to continue until it stabilizes in 2014. Looking at return on tangible equity to eliminate distortions related to goodwill adjustments, we expect the Canadian banking industry to earn an ROTE of 21.5% in 2013 and 20.7% in 2014 compared to 28.5% in 2007, the last year before the financial crisis began distorting ROAs and before banks started to build up capital levels. The decline in forecast ROTE is partly driven by lower expected ROA (0.81% versus 0.92%) but also by lower expected leverage (we expect assets to tangible equity of 26- 27x versus 31x in 2007 and a peak of 33x in 2008) (Exhibit 5).

September 18, 2013 31 Canadian Bank Primer, Sixth Edition

Exhibit 12: Banks’ revenues are less dependent on net interest income than 1980s/early ’90s

Bank Revenue Breakdown (Annual Since 1980) 90%

80%

70%

60% 53.4% 50% 46.6% 40%

30%

20%

10%

0% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Non-Interest Income as % Total Revenue Net Interest Income as % Total Revenue

The adoption of IFRS in 2011 led to securitized mortgages being brought back on balance sheets, to the benefit of net interest income and detriment of non-interest income. Median of Big Six Banks. Source: Company reports, RBC Capital Markets

September 18, 2013 32 Canadian Bank Primer, Sixth Edition

SECTION 3: The Canadian Landscape This section addresses the size of the Canadian banks, their importance in Canadian financial services, and the Canadian stock market. We detail key regulatory issues and provide a historical overview of bank profitability, capitalization, and milestones.

The Big Six Canadian banks7 are the largest players in all areas of the Canadian financial landscape, except for insurance. The six banks:

 hold about 65–75% market share in several retail banking products such as residential mortgages, credit cards, and retail deposits (when including all competitors such as insurance companies, trusts, and credit unions);  are the largest players in retail brokerage, with an estimated 77% share of full-service brokerage assets and more than 85% of online-discount brokerage assets; and  are large in capital markets, with leading positions in corporate lending, advisory, and trading businesses.

Foreign competition is limited to certain niches such as credit cards (Amex and Capital One) and investment banking (Bank of America/Merrill Lynch, UBS, and Credit Suisse). Only HSBC competes in most product lines, but it remains much smaller than its Big Six competitors; with total assets of $84 billion, HSBC’s Canadian operations are almost half the size of National Bank, which is the smallest of the Big Six Banks.

 Foreign competition tends to increase in good economic times and tends to decline in weak economic times as foreign firms review their need to be in foreign jurisdictions when the environment for profitability is more difficult. Canadian banks, on the other hand, remain committed to Canada during good and bad economic times.  The entrance and exit of foreign competition is particularly noticeable in areas where physical infrastructure is less of a relative advantage. For example, foreign investment banks typically increase their presence in Canada in booming times for capital markets but are normally quick to reduce their presence in poorer times. The same holds true for corporate lending (both traditional business lending and real estate lending). In the 2008–2009 recession, this theme also played out in consumer lending, with players such as Household Finance, Wells Fargo, GE Money, and the automobile companies’ captive finance arms sharply reducing or eliminating their consumer lending businesses. Some of those lenders have returned since the recession ended.

Other financial services companies that compete with the Big Six banks include regional or niche players including two smaller publicly traded Canadian banks and credit unions.

 Two regional banks are publicly traded: Canadian Western Bank and Laurentian Bank. Canadian Western Bank has a market capitalization of $2.4 billion and assets of approximately $18 billion, with a majority of earnings from Western provinces. Laurentian Bank has a market capitalization of over $1.3 billion and assets of approximately $34 billion, with most of its earnings coming from Quebec.  Credit unions (caisses populaires) are popular in Canada, particularly in Quebec and in Western provinces. Desjardins is the largest bank-like financial institution competing with banks in Quebec, with assets of $205 billion, loans of $137 billion, and AUM of $313 billion. Desjardins has 930 branches with leading market share in the province including 36% share in Quebec residential mortgage credit, 23% consumer credit, and 24%

7 The Big Six Banks include Bank of Montreal, Scotiabank, CIBC, National Bank of Canada, Royal Bank of Canada, and TD Bank. These six banks account for $3.3 trillion of the $3.7 trillion in total bank assets in Canada. September 18, 2013 33 Canadian Bank Primer, Sixth Edition

business credit in Quebec. Outside Quebec, credit unions are smaller in size with only three having assets above $10 billion: Vancity in British Columbia ($17 billion); Coast Capital Savings in British Columbia ($15 billion); and Servus Credit Union in Alberta ($11 billion). Across Canada, there are about 740 credit unions and caisse populaires with $250 billion of loans and $300 billion of assets (according to Credit Union Central of Canada).  Alberta Treasury Branches, or ATB Financial, is a provincial Crown corporation and is a large bank-like institution competing with banks in Alberta, with assets of $33 billion, loans of $28 billion, and 171 branches.  Other niche players focus on specific retail and wholesale products and services such as wealth management, capital markets (Richardson GMP and CanaccordGenuity), and mutual funds (CI, Fidelity Investments, AGF, and IGM Financial).  Schedule 1 banks are domestic banks authorized under the Bank Act to accept deposits, including Bank of Montreal, Scotiabank, CIBC, National Bank, Royal Bank of Canada, TD Bank, Canadian Western Bank, and Laurentian Bank, among others. Schedule 2 banks are foreign-bank subsidiaries, and Schedule 3 banks are foreign-bank branches, which together make up 6% of total bank assets in Canada.8 (Exhibit 13)

Exhibit 13: Big Six banks have most of the bank assets in Canada

Total Assets (As at July 31, 2013 or most recent quarter)

900,000

800,000

700,000

600,000

500,000

400,000

300,000

200,000

100,000

0 Royal Bank TD Bank Scotiabank Bank of CIBC National HSBC Laurential ATB Canadian Montreal Bank Bank Financial Western Bank

Note: Does not include credit unions. Desjardins has ~$205 billion of assets, which would rank sixth-largest. Source: Company reports, RBC Capital Markets Research

The Big Six banks are important components of the S&P/TSX Composite Index, accounting for 22% of the weight of the index and two-thirds (66%) of the weight of the S&P/TSX Financials Index, as of August 31, 2013. The banks’ weight is in line with its peak of 22% in 2003 but up from its low of 15% in late 2008 (Exhibit 14). Other key sectors in the main Canadian composite index are Energy (25%) and Materials (14%). No other sector makes up more than 6% of the composite index.

8 Schedule 2 and 3 banks have ~$250 billion of assets. September 18, 2013 34 Canadian Bank Primer, Sixth Edition

 The Big Five Banks9 are among the larger and more widely held names in the S&P TSX Composite Index. (Exhibit 15). Their importance in the S&P TSX Composite Index far exceeds the importance of US banks in the S&P 500 Index, and the makeup of the remainder of the index is much more weighted toward energy/mining in the Canadian index than it is in the US index. (Exhibit 15)  The Big Six Banks are among the top-20 banks in North America, as measured by market capitalization, with their relative rankings having benefited from declines in the share prices of US banks since 2007. (Exhibit 16).

Exhibit 14: Banks’ weight in S&P/TSX index is around 22%

Canadian Bank Index Weight in S&P TSX Index (Since 1990) 24%

22%

20%

18%

16%

14%

12%

10% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

As of August 31, 2013, Canadian Bank Index, S&P/TSX Composite Index. Source: RBC Capital Markets Quantitative Research, RBC Capital Markets

Exhibit 15: Canada’s Big Five banks among the top-20 companies in the S&P/TSX Index; US banks not as large in S&P

$ billions Top S&P/TSX Companies by Market Capitalization $ billions Top 20 S&P 500 Companies by Market Capitalization 100 500 90 450 80 400 70 350 60 300 50 250 40 200 30 150 20 100 10 50 0

CIBC

IBM

Cola

Mart

Pfizer

BCE Inc BCE

Merck

Apple Apple

Valeant Valeant

Google

Goldcorp

Enbridge Enbridge

Chevron

AT&T Inc AT&T

Citigroup

Wal

Microsoft

West Lifeco West

Coca

Wells Fargo Wells

Oracle Corp Oracle

Exxon Mobil Exxon

Suncor Energy Suncor

Dominion Bank Dominion

Imperial Oil Ltd Oil Imperial

Husky Energy Inc Energy Husky

General Electric General

Bank of Montreal of Bank

Thomson Reuters Thomson

Bank of America of Bank

Great

Manulife Financial Manulife

JP Morgan Chase Morgan JP

Procter & Gamble & Procter

Cenovus Energy Inc Energy Cenovus

Bank of Nova Scotia Nova of Bank

Johnson & Johnson & Johnson

Royal Bank of Canada of Bank Royal

Berkshire Hathaway Berkshire

TransCanada PipeLines TransCanada

Toronto

Canadian National Railway National Canadian

Canadian Natural Resources Resources Natural Canadian Potash Corp of Saskatchewan of Corp Potash

As of August 31, 2013 Source: Bloomberg, RBC Capital Markets

9 The Big Five banks include Bank of Montreal, Scotiabank, CIBC, Royal Bank, and TD Bank. The Big Six banks also include National Bank. September 18, 2013 35 Canadian Bank Primer, Sixth Edition

Exhibit 16: Canada’s Big Six banks among the top-20 largest in North America by market cap

$ billions Top North American Banks by Market Capitalization 250

200

150

100

CIBC

BB&T BB&T

Keycorp

Suntrust

Citigroup

M&T Bank M&T

US Bancorp US

Wells Fargo Wells

PNC Financial PNC

Dominion Bank Dominion

Goldman Sachs Goldman

Morgan Stanley Morgan

Bank of America of Bank

JP Morgan Chase Morgan JP

Bank ofMontreal Bank

Regions Financial Regions

Fifth Third Third Bancorp Fifth

Bank ofNovaScotia Bank

Royal Bank Bank ofCanada Royal

Toronto National Bank Canada Bank Of National

As of August 31, 2013. Source: Bloomberg, RBC Capital Markets

Canadian Banks have been solid investments in the medium and long term.  Canadian bank stocks delivered solid total returns to shareholders (including dividends), which have grown at a CAGR of 11% in the last 5 and 10 years, and 13% in the last 20 years. The number of good years has far exceeded the bad years in number and magnitude (Exhibit 17).

Exhibit 17: Long-term returns for Canadian bank stocks have been attractive

5-year 10-year 20-year

18% 18% 20% 16% 16% 18% 14% 14% 16% 14% 12% 12% 12% 10% 10% 10% 8% 8% 8% 6% 6%

Total return(%) CAGR Total return(%) CAGR Total Total return(%) CAGR Total 4% 4% 4% 2% 2% 2%

0% 0% 0%

LB LB LB

RY RY RY

TD TD TD

NA NA NA

CM CM CM

TSX TSX TSX

BNS BNS BNS

CWB CWB CWB

BMO BMO BMO

TSX Banks TSX Banks TSX TSX Banks TSX

TSX Financials TSX Financials TSX Financials TSX

As of Sept 9, 2013. STBANKXR is the SPTSX Bank Index. STFINL Index is the SPTSX Financials Index, which includes banks, insurance, and Real Estate Investment Trusts. Source: Bloomberg, RBC Capital Markets

In the past 57 years, bank returns were positive 43 times (and outperformed the TSX composite index 36 times including in 19 of the last 25 years) and were negative 14 times (and underperformed the index 20 times). Bank shares have historically performed best late in the year (Exhibit 19).

September 18, 2013 36 Canadian Bank Primer, Sixth Edition

Exhibit 18: Bank returns were positive in 75% of the years since 1957 and outperformed the Canadian market in 65%

Canadian Bank Index Total Returns* Canadian Bank Relative Total Return (vs. TSX) (Since 1957) (Since 1957) 80% 60%

50% Banks Outperform TSX 60% 40%

30% 40% 20%

20% 10%

0% -10%

-20% Banks Underperform TSX -20% -30%

-40% -40% 57 62 67 72 77 82 87 92 97 02 07 12 57 62 67 72 77 82 87 92 97 02 07 12 Canadian Bank Index Relative to TSX (Bank Total Return minus TSX Total Return)

*Share price appreciation + dividends reinvested. Based on eight publicly traded banks; prior to 1980 includes banks and trusts. As of August 31, 2013. Source: RBC Capital Markets Quantitative Research, Bloomberg, RBC Capital Markets

Exhibit 19: Bank shares have historically performed best late in the year

Price Return Seasonality (1980 to 2012)

Banks Average Monthly S&P/TSX Composite Average Banks Average Monthly Return Month Return 1 Monthly Return Relative to TSX 2

January -0.17% 1.03% -1.19% February 0.65% 0.77% -0.12% March 1.23% 0.55% 0.68% April 0.98% 0.83% 0.16% May 1.49% 1.53% -0.04% June -0.88% -0.44% -0.44% July 1.48% 0.76% 0.72% August 0.40% 0.53% -0.13% September -0.41% -1.70% 1.29% October 2.18% 0.02% 2.16% November 2.19% 1.39% 0.81% December 1.66% 1.93% -0.27%

1 - Canadian Bank Index Price Return since 1980; 2 - Relative Return is Bank Index return minus S&P/TSX Composite Price return. Source: Bloomberg, RBC Capital Markets Quantitative Research, RBC Capital Markets

Canadian banks have good track records of growth in earnings, dividends, and profitability.

 Annual core earnings growth has averaged 11% for the last 20 years (Exhibit 20). Earnings growth has been volatile, with economic health and capital markets activity being the two main near-term drivers of volatility. Loan growth normally slows in an economic slowdown and credit losses rise (with a lag). Direction and activity in capital markets are also important sources of near-term volatility (to the upside and downside) because the banks generate 25–30% of their revenues from market-sensitive sources in normal environments (Exhibit 21).  Analysts should be careful in using the 11% long-term growth rate as an indication of optimism or pessimism when looking at earnings growth forecasts. As Exhibit 20

September 18, 2013 37 Canadian Bank Primer, Sixth Edition

illustrates, earnings growth is almost never between 0% and 10%. It is either negative (usually in recessions or period of market stress) or greater than 10%.

Sensitivity to capital markets has increased. ROE dropped to 13% in 2009 from 21% in 2007 because of capital markets-related writedowns and negative growth in wealth management revenue, as well as rising loan losses. ROE has since risen to ~18% because of the decline in loan losses as well as an improvement in capital markets and wealth management revenues, partially offset by lower leverage.

 Sensitivity to capital markets led to banks’ suffering profitability pressure earlier in the 2008 –2009 economic downturn than they did in the early 1980s and 1990s, but it also led to banks’ profitability not dropping as much during the recession and recovering sooner.

Exhibit 20: Earnings growth is usually greater than 10% or negative

Canadian Bank Index YoY Recurring Earnings Growth (Quarterly since 1988) 40%

30%

20%

10%

-10%

-20%

-30% 88 90 92 94 96 98 00 02 04 06 08 10 12 14E

Shaded area represents recession

Source: RBC Capital Markets Quantitative Research, RBC Capital Markets estimates

Exhibit 21: Banks generate 25-30% of revenues from market-sensitive sources in normal environments

Market Sensitive Revenue as % of Total Revenue * 2005 2006 2007 2008 2009 2010 2011 2012 Median 2013YTD BMO 29% 31% 33% 32% 23% 25% 26% 26% 26% 26% BNS 22% 21% 20% 11% 16% 21% 21% 21% 21% 20% CM 34% 35% 32% n.m. 15% 22% 19% 16% 30% 18% NA 34% 38% 34% 15% 24% 22% 23% 24% 31% 23% RY 31% 36% 34% 21% 25% 28% 27% 28% 32% 29% TD 24% 23% 23% 12% 14% 16% 13% 13% 23% 12% Median 30% 33% 32% 15% 20% 22% 22% 23% 28% 22% YoY change (basis points) -180 288 -49 -1758 484 244 87 79

* Includes special items. Market-sensitive revenue includes Underwriting and Advisory, Brokerage, Trading, Mutual Fund, and Investment Securities Revenues; n.m. - not meaningful due to an extraordinary event. Source: Company reports, RBC Capital Markets

September 18, 2013 38 Canadian Bank Primer, Sixth Edition

Dividend payout ratios have been in the range of 40–50% of earnings in recent “normal” years (the median payout ratio for the Big Six Banks from 2000 to 2008 was 40%). Dividend growth was very strong from 2000 to 2007 with growth rates ranging from 13% to 28% per year, but dividend increases were rare from 2008 to 2010. All of the eight publicly traded banks have resumed dividend increases since the end of the 2008–2009 recession.

 Canadian banks have been very committed to their dividends, maintaining them during severe recessions and very difficult capital markets environments, whereas many foreign peers have historically been quicker to reduce dividends. Since the 1940s, only National Bank has had to cut its dividend (in the early 1980s and again in the early 1990s) despite industry dividend payout ratios reaching more than 70% in the mid- 1960s, 88% in late 1990, and 119% in early 1993. During the financial crisis and most recent recession, payout ratios were high for several banks including National Bank (72% in 2007), Bank of Montreal (75% in 2008 and 92% in 2009), and CIBC (which lost money in 2008 because of large capital markets-related writedowns and 132% in 2009), yet these banks maintained their dividends. We believe that the banks historically avoided cutting dividends because a significant portion of their shareholder base is made up of retail investors (we believe 40–50% of the total shareholder base), many of whom place a high value on dividends received.  The combination of income growth, internal capital generation, and greater clarity on regulatory capital rules positions the Canadian banks to consider dividend increases, balance sheet optimization, and other capital deployment. All eight banks have increased their dividends since the end of the recession, and we expect dividends to continue to grow in line with EPS growth.  Our optimism on dividend increases is a result of the earnings recovery that the banking system has experienced as the economy has recovered, combined with a greater degree of clarity on evolving regulatory capital rules. While we expect dividend increases, we expect a slower growth rate than investors were accustomed to in the 2000-2007 period. Dividend growth was rapid during that period for two reasons: (1) earnings per share growth was rapid (CAGR of 11%); and (2) dividend payout ratios rose to 40% from about 30%. We believe dividend increases will continue; however, the dividend increases will likely be in line with earnings growth (so dividend growth should not exceed EPS growth as was the case from 2000 to 2007).

September 18, 2013 39 Canadian Bank Primer, Sixth Edition

Exhibit 22: Dividend payout ratios had trended up until 2009 and have declined since then

Big 6 banks Regional Banks Dividend Payout Ratios BMO BNS CM NA RY TD Median CWB LB Last Stated Target Payout Ratio 40%-50% 40%-50% 40%-50% 40%-50% 40%-50% 40%-50% 25%-30% 40%-50%

2000 31% 28% 26% 29% 31% 21% 29% 13% 27% 2001 42% 30% 31% 26% 38% 25% 30% 14% 32% 2002 41% 34% 92% 59% 38% 65% 50% 17% 92% 2003 37% 35% 38% 32% 38% 31% 36% 15% 78% 2004 35% 39% 40% 47% 43% 37% 40% 24% 235% 2005 40% 41% 39% 37% 41% 37% 39% 21% 65% 2006 43% 42% 37% 38% 40% 38% 39% 22% 53% 2007 48% 43% 34% 40% 43% 36% 41% 23% 40% 2008 65% 49% 50% 45% 47% 44% 48% 26% 34% 2009 69% 57% 63% 40% 46% 47% 52% 29% 36% 2010 58% 48% 53% 39% 50% 42% 49% 20% 32% 2011 55% 46% 46% 38% 47% 38% 46% 24% 33% 2012 47% 47% 45% 39% 46% 39% 46% 27% 37% Based on current dividend: 2013E 48% 48% 44% 42% N/A 45% 45% 30% 38% Based on forecast dividend 2013E 48% 48% 44% 42% N/A 46% 46% 29% 38% Based on current dividend: 2014E 46% 45% 46% 40% N/A 40% 45% 26% 36% Based on forecast dividend 2014E 48% 48% 48% 44% N/A 45% 48% 28% 40% Based on current dividend: 2015E 45% 42% 43% 38% N/A 36% 42% 24% 34% Based on forecast dividend 2015E 49% 49% 47% 44% N/A 44% 47% 28% 42%

Median 2003-2012 48% 45% 42% 39% 44% 38% 43% 23% 39%

% Change 2000 to 2012 16% 18% 19% 10% 15% 18% 17% 14% 10%

Payout ratio = common dividend / core, cash net income to common. Target ratios have changed during the years. Source: Company reports, RBC Capital Markets estimates

September 18, 2013 40 Canadian Bank Primer, Sixth Edition

Exhibit 23: Dividend growth had been high from 2000 to 2007; we expect slower growth rates in future years

Dividend Growth Detail Big Six Banks Regional Banks BMO BNS CM NA RY TD Median CWB LB 2000 6% 15% 8% 7% 21% 28% 11% 6% 2% 2001 12% 24% 12% 9% 21% 18% 15% 6% 13% 2002 7% 17% 11% 13% 10% 3% 11% 11% 9% 2003 12% 16% 3% 16% 13% 4% 12% 15% 0% 2004 19% 31% 34% 31% 17% 17% 25% 30% 0% 2005 16% 20% 21% 21% 16% 16% 18% 27% 0% 2006 22% 14% 4% 14% 23% 13% 14% 32% 0% 2007 20% 16% 13% 16% 26% 19% 17% 36% 0% 2008 3% 9% 12% 9% 10% 12% 10% 24% 12% 2009 0% 3% 0% 0% 0% 3% 0% 5% 5% 2010 0% 0% 0% 2% 0% 0% 0% 5% 8% 2011 0% 6% 2% 12% 6% 10% 6% 22% 14% 2012 1% 7% 4% 12% 10% 11% 8% 14% 12% 2013E 4% 9% 4% 10% n/a 11% 9% 13% 9% 2014E 5% 8% 4% 11% n/a 13% 8% 10% 11% 2015E 5% 9% 3% 6% n/a 7% 6% 6% 7% Median Growth 2003-2012 7% 11% 4% 13% 12% 12% 11% 23% 2%

% Change Q1/00 to Q3/13 196% 400% 220% 383% 367% 305% 336% 757% 117%

Source: Company reports, RBC Capital Markets estimates

Canadian banks have historically earned high ROEs, and that has increased in the past few decades because banks diversified beyond capital-intensive lending businesses and grew low-capital fee businesses. Banks are not immune to the volatility in economic slowdowns, but their increased diversification should mitigate some of the downside risk seen in bad years (the industry last lost money in the mid 1980s) (Exhibit 24 and Exhibit 25).

 With banks having grown their wealth management, insurance, and capital markets businesses, they now have more sources of revenues that can help offset rising loan losses that were not necessarily available in the early 1980s or 1990s.  ROE peaked at 23% for the Big Six Banks in 2006, which reflected buoyant equity and capital markets, and low loan losses. We believe that “normal” ROE, based on the current business mix, is closer to the 16–18% range. ROE was 13% in 2009 because of capital markets-related writedowns as well as tough economic and capital markets conditions, and 16% in 2010 because of high loan losses, but returns improved to 20% in 2011 in spite of banks holding more capital and liquidity than in the past as credit losses declined. So far in 2013, ROEs have been 16-17% in spite of banks holding more capital than in the past as provisions for credit losses have declined and writedowns have been negligible.  New regulatory capital rules have had a negative effect on bank ROE relative to the 2006–2007 period (21–23%). All banks currently meet the new Basel III capital rules, which were introduced by the Office of the Superintendent of Financial Institutions (OSFI) in early 2013, and we believe that the negative impact to bank ROE due to the capital build is now largely behind us. We are currently forecast ROE of ~16% in 2014 and 2015, in line with where we see ROE stabilizing over the medium term. Basel III common equity Tier 1 ratios for the Big Six banks now range from 8.6% at National Bank to 9.6% at Bank of Montreal. OSFI’s required minimum is 8.0%, which includes a 1% domestic systematically important bank (D-SIB) buffer. Canadian banks historically have September 18, 2013 41 Canadian Bank Primer, Sixth Edition

had capital ratios in excess of minimum OSFI targets, and we think a 0.5-1.0% cushion is reflective of what banks in general might target. CIBC and Bank of Montreal are currently over 9.0% already, whereas we expect the other three large cap banks we cover to reach that level by the second half of 2014.

Exhibit 24: ROE had trended higher until 2007

Return on Equity - Historical Summary (since 1982) 30-yr Avg 20-yr Avg 10-yr Avg 5-yr Avg 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E BMO 14% 17% 16% 14% 15% 13% 10% 15% 14% 16% 15% 15% 14% BNS 15% 18% 19% 19% 22% 17% 17% 19% 20% 20% 17% 16% 16% CM 12% 13% 14% 14% 29% -19% 9% 19% 21% 23% 21% 21% 20% NA 12% 15% 17% 18% 12% 17% 16% 17% 20% 25% 21% 18% 17% RY 16% 17% 19% 20% 26% 18% 17% 17% 20% 20% n/a n/a n/a TD 15% 16% 16% 15% 19% 16% 11% 13% 16% 15% 15% 16% 16% Median 14% 16% 16% 16% 21% 17% 13% 17% 20% 20% 17% 16% 16%

10 yr Bond Yield 7.08% 5.08% 3.68% 2.96% 4.24% 3.72% 3.21% 3.22% 2.93% 1.78% n/a n/a n/a

10-year Government of Canada Bond Yield. Averages are until 2010 (i.e., 30-year average is the average ROE from 1981-2010). Reported cash ROE includes special items, excludes preferred dividends, goodwill, and intangibles. Source: Company reports, Bloomberg, RBC Capital Markets estimates

Most of the banks’ revenues and earnings are in Canada, and Canadian revenues are mostly originated in central Canada.

 Approximately 65–70% of revenue and 75–80% of earnings are domestic (Exhibit 25).  Approximately 54% of the Big Six Banks’ domestic loans are in Ontario, followed by Alberta and the Prairies (17%), British Columbia (14%), and Quebec (10%).  The two regional banks’ revenues and earnings are all originated in Canada, with most of Canadian Western Bank’s contributions from Alberta and BC, and most of Laurentian Bank’s contributions from Quebec.

Exhibit 25: Approximately 20-25% of Big Six bank earnings generated outside Canada

Banks: Non-Canadian Exposure

47% 46% 37% 34%34% 34% 30%

20% 17% 13% 4% 1%

BNS BMO TD RY CM NA

% of 2012 Revenue % of 2012 Net Income

Source: Company reports, RBC Capital Markets

September 18, 2013 42 Canadian Bank Primer, Sixth Edition

Regulation – Key things to know Banks are heavily regulated entities, and investors must be aware of the regulatory framework under which they operate.

OSFI is the main regulator for banks. OSFI is a branch of the federal government that regulates all banks operating in Canada. It works together with other government agencies to maintain a stable and fair financial services sector in Canada. The Bank Act is the legislation under which the banks are allowed to operate. The banks’ businesses are also subject to oversight by many other bodies both in Canada and abroad, including securities regulators, other bank-supervisory organizations, deposit-insurance agencies, and consumer protection agencies. The most relevant regulatory constraints that investors should be aware of are outlined below:

 Government agencies that OSFI works closely with include: the Bank of Canada, which controls monetary policy; Canadian Deposit Insurance Corporation (CDIC), which insures depositors are able to recoup their money up to a certain amount10 in the event of a bank failure; and the Financial Consumer Agency of Canada, a consumer protection advocate for financial services activities.  Minister of Finance approval is required for any person to own more than 10% of a large bank. Under the Bank Act, shares of large banks (with equity greater than $12 billion) must be widely held; shares of medium-sized banks (with equity between $2 billion and $12 billion) must be publicly held by at least 65%; and smaller banks do not have ownership restrictions.11 Subject to the Minister of Finance’s approval, a person may own up to 20% of any class of voting shares and up to 30% of any class of non- voting shares for large banks. The Bank Act prohibits further ownership or acquiring control of a large bank, but there are no restrictions for smaller banks other than needing Minister approval for acquiring a significant interest. There are no official foreign-ownership restrictions, but there are additional subjective hurdles if the transaction involves a foreign bank that is not a member of the World Trade Organization. The entry of foreign-controlled institutions is subject to approvals by the OSFI and the Minister of Finance.  In 1998, the Minister of Finance turned down the proposed mergers between Royal Bank and Bank of Montreal, and CIBC and TD. It was also widely reported, but never officially confirmed, that Bank of Montreal and Scotiabank had a merger proposal denied by the government in 2002. No formal political position for or against bank mergers has been established since. Politically, it may be difficult to support mergers or foreign takeovers because polls have historically shown that Canadians do not support bank mergers.  Banks are only allowed to sell certain insurance products in their bank branches, which include creditor life, travel, and mortgage insurance. Banks cannot promote life insurance and/or home and auto insurance in their branches. These provisions are part of the Bank Act, which is reviewed every five years. It was recently reviewed in April 2012 without insurance-related changes, and the next sunset date for changes will be in April 2017, which means that a substantive review will likely start in 2015.  We believe that, in time, the restrictions on selling insurance products in branches will be lifted or, at the very least, loosened. If and when that happens, the banks’ brands and distribution infrastructure would likely allow them rapidly to gain share in commodity-like products such as home and auto insurance, as well as

10 Canadian dollar savings, chequing accounts, and GICs of five years or less are insured up to $100,000. 11 We understand that banks with less than $12 billion of equity including National Bank and Canadian Western Bank are still considered large banks due to grandfathering provisions, so the widely held rule would still apply. September 18, 2013 43 Canadian Bank Primer, Sixth Edition

term life insurance. More complex insurance offerings, such as universal life and segregated funds, are more complicated to sell, and banks would need to hire qualified sales agents to grow in those products, which would take time. For three banks (TD Bank, Royal Bank and Bank of Montreal), insurance is a significant business even though it has not been fully integrated into the retail branch network.

History: Since 1990 Now that we have reviewed the landscape in which banks compete, the perspective on the evolution of the banks during the last 23 years should provide investors with a good understanding of how banks have changed (or not), as well as our thoughts on the future direction of some of the trends seen in the last two decades.

Canada’s economic health has changed dramatically since 1990 (for the better), which has provided the banks with an accommodating backdrop against which to grow their earnings and dividends, diversify their operations, and strengthen their capital bases. Even after the 2008–2009 increase in unemployment, most economic metrics are better today than they were in the early 1990s.

 The current unemployment rate of 7.1% compares to approximately 11% in the early– mid 1990s. (Exhibit 26).  Inflation is around 1.3% compared to nearly 3.5% in early 1990, and five-year bond yields have also declined to 2.1% from 10–12% (Exhibit 26).  Housing prices have increased by a CAGR of 4.3%, with much of the appreciation occurring in the 2000s (8%) (Exhibit 26).  Corporate tax rates have declined since 1990. For example, the top combined corporate tax rate declined to 32% as of August 2013 from 45% in 1990.12  Debt-to-GDP stood at 38% in 2012 versus 43–55% in the early 1990s (Exhibit 26).  The Canadian dollar appreciated against the US dollar ($0.85 in 1990 to $0.97 today) while the spread between five-year US Treasury bonds and five-year Government of Canada bonds went to about -0.7% from -2.5%.

12 Tax rates combine federal and provincial rates (including surtaxes and abatements). Corporate tax rates are for non-manufacturing large corporations. The top corporate tax rate was in Manitoba and Newfoundland in 1990 and in PEI and Nova Scotia today, while the top personal tax rate was in Quebec in 1990 and in Nova Scotia today. September 18, 2013 44 Canadian Bank Primer, Sixth Edition

Exhibit 26: Canada’s economic health has changed (for the better) since 1990

Core Inflation Unemployment Rates (Since 1990) (Since 1976) 5% 15%

13% 4%

11%

7% Core Consumer Price Index YoY Index Price CoreConsumer

5% 1%

3% 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Canadian Unemployment Rate U.S. Unemployment rate 5-Year Canada Bond Yields Existing home sales price (YoY % chg) (Since 1990) (Since 1981) 13% 30%

12% 25%

11% 20% 10% 15% 9%

8% 10%

7% 5%

6% 0% 5% -5% 4%

3% -10%

2% -15% 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 1% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Canada

Canadian Debt-to-GDP USD/CAD (Since 1990) 1.10 70% 1.05

1.00 60% 0.95

0.90 50% 0.85

40% 0.80

0.75 30% 0.70

Unmatured Government GDP Nominal Government Debt/ Unmatured 0.65 20% 0.60

0.55 10% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 0.50 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12

Source: Bloomberg, IMF, Statistics Canada, Department of Finance Canada, Haver, RBC Capital Markets

The early 1990s were a difficult period for banks. With banks already weakened in the mid- to-late 1980s by losses related to less developed countries, the Canadian economy entered into a recession.

 Loan losses spiked to 1.5% of loans in 1992, the second-highest loss rate in the 30 years for which we have data. The highest was 2.8% in the late 1980s (Exhibit 27).

September 18, 2013 45 Canadian Bank Primer, Sixth Edition

 Consumer loan losses rose to a peak of 1.4% of loans as the unemployment rate spiked to 12% from 7% (Exhibit 27).  Business-loan losses spiked to 2.4% of loans (Exhibit 27), led by commercial real estate loans, which reshaped how banks have lent in the commercial real estate sector since then because the memories of the early 1990s losses in that sector remain with senior bankers and risk managers.  Growth in consumer loans stalled, while business loan balances declined (Exhibit 3).  ROE declined to 5% for the Big Six Banks, and the banks traded at approximately book value (Exhibit 28).  National Bank had to cut its dividend by 50% in 1992. (It also did so in the early 1980s and has been the only bank to cut dividends since the 1940s.)

Exhibit 27: Loan losses are cyclical, driven by economic cycles; recent peaks have been lower

Loan Loss Provisions % of Loans and Revenue Provisions for Credit Losses by Product (Annual since 1977) (Annual since 1990) 3.0% 60% 3.0% Average PCLs (since 1990): Residential Mortgages: 0.03% 2.5% 2.5% 50% Consumer Loans: 1.06% Business and Government Loans: 0.73% 2.0% Total Loans: 0.58% 2.0% 40%

1.5% 1.5% 30%

1.0%

1.0% 20% 0.5%

0.5% 10% 0.0%

0.0% 0% -0.5% 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13E 15E 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E

Total Loans* Consumer Loans Total PCL as % of Loans (LHS) Total PCL as % of Revenue (RHS) *based on total PCLs Residential Mortgage Business & Gov't

Loan loss provision as a % of loans and revenue are total of Big Six Banks, and reported revenue includes special items; Total PCL is average of Big Six Banks. Source: Company Reports, RBC Capital Markets estimates

Exhibit 28: P/B multiples are highly correlated with ROE

Canadian Bank Index - P/B vs ROE (Since 1980) Correlation Coefficient: 0.46 3.0x 30%

2.5x 25%

2.0x 20%

1.5x 15%

1.0x 10%

0.5x 5%

0.0x 0% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Canadian Bank Index P/B (LHS) Canadian Bank Index ROE (RHS)

As of August 31, 2013. Source: RBC Quantitative Research, RBC Capital Markets

September 18, 2013 46 Canadian Bank Primer, Sixth Edition

After the early 1990s recession, the Canadian economy entered a period of declining inflation, interest rates, and unemployment, which made for a very good backdrop for lending growth and loan losses. Consumer attitudes toward debt, as well as increased willingness of banks to lend to retail customers, led to a cycle of increased leverage (as measured against disposable income), which led to retail-loan growth in excess of disposable income. Leverage, as measured by debt servicing, declined because declining interest rates lowered borrowing costs. Credit losses declined until the late 1990s, when they rose again, reaching a peak of 1.2% of loans in 2002 (Exhibit 27).

 Unlike the early 1990s, the losses in the early 2000s were not due to a weak Canadian economy but rather to expansion into areas that proved problematic for banks worldwide, particularly telecommunications, media and cable, and the power industry. The spike in loan losses was particularly acute for banks with exposure to those areas. TD, CIBC, and Scotiabank were most affected by loan losses in 2001–2002 (Exhibit 30). Those banks paid an expensive price to learn a lesson that has been applied more diligently by banks since then and helped in the most recent recession: strict single- name limits and industry-concentration limits reduce risk in credit downturns.  ROE for the industry declined to about 10% in 2002, well down from the peak of almost 19% in 2000, but twice the ROE of the early 1990s trough, mainly because the banks were less dependent on credit risk, and generated more wealth management and capital markets revenues than in the early 1990s. Evidence of the banks’ lower exposure to traditional credit risk includes:  Loans as a percentage of balance sheet assets declined to about 47% in 2002 from 70% in the 1980s and early 1990s.  Loans as a multiple of common equity also declined to about 11x in 2002 from 17x in the early 1990s (Exhibit 31).  Net interest income as a percentage of revenues declined to 50% from 80% in the early 1980s (Exhibit 12).

Exhibit 29: Household debt in Canada has risen since 1990, but debt servicing has improved

Household debt to Personal disposable income Household Debt Service Burden % (Based on credit market debt) (Since 1990) 180 15%

On average, U.S. households spend 14% of 14% their personal disposable income (PDI) on 160 healthcare vs. 4% in Canada due to 13% differences in each country's healthcare system. Deducting this "core" expense from 12% 140 PDI, U.S. household debt to PDI is approximately 6% higher than Canada. 11%

120 10%

100 8%

7% 80 6%

60 5% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Canada U.S. U.K. Australia Canada Gross Debt Service Burden U.S. Gross Debt Service Burden

Data as of March 2013. Source: RBC Economics, Statistics Canada, RBC Capital Markets

September 18, 2013 47 Canadian Bank Primer, Sixth Edition

Exhibit 30: Provisions for credit losses rose more for TD, CIBC, and Scotiabank in the early 2000s

Total PCL and ROE

Total PCL as % of Loans 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E BMO 0.31% 0.81% 0.65% 0.36% -0.08% 0.13% 0.12% 0.23% 0.80% 0.94% 0.63% 0.56% 0.32% 0.22% 0.35% 0.32% BNS 0.53% 0.96% 1.29% 0.52% 0.01% 0.14% 0.11% 0.12% 0.24% 0.62% 0.45% 0.35% 0.37% 0.32% 0.35% 0.35% CM 0.99% 0.84% 1.10% 0.83% 0.46% 0.50% 0.38% 0.39% 0.46% 0.96% 0.60% 0.48% 0.53% 0.45% 0.35% 0.37% NA 0.45% 0.50% 1.22% 0.46% 0.21% 0.08% 0.17% 0.21% 0.23% 0.34% 0.26% 0.26% 0.23% 0.20% 0.22% 0.24% RY 0.51% 0.72% 0.63% 0.44% 0.21% 0.26% 0.21% 0.35% 0.60% 1.03% 0.46% 0.33% 0.36% n/a n/a n/a TD 0.47% 0.77% 2.41% 0.15% -0.31% 0.04% 0.26% 0.38% 0.54% 1.04% 0.62% 0.39% 0.46% 0.40% 0.46% 0.45% Median 0.49% 0.79% 1.16% 0.45% 0.11% 0.14% 0.19% 0.29% 0.50% 0.95% 0.53% 0.37% 0.36% 0.32% 0.35% 0.35%

ROE (reported, cash) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E BMO 19.3% 15.3% 14.2% 17.1% 20.1% 19.4% 19.5% 14.7% 13.2% 10.0% 15.1% 15.6% 16.2% 15.1% 14.9% 14.2% BNS 17.9% 17.7% 13.2% 17.8% 20.0% 21.0% 22.3% 22.0% 17.0% 17.0% 19.1% 20.7% 20.1% 16.7% 16.1% 15.8% CM 21.1% 16.7% 5.7% 19.4% 18.8% -1.8% 27.9% 28.9% -18.2% 9.8% 19.8% 22.4% 22.2% 21.1% 21.2% 19.6% NA 14.7% 16.8% 8.3% 16.0% 15.0% 17.1% 19.1% 11.6% 16.5% 15.5% 17.0% 20.7% 24.6% 20.9% 18.1% 17.4% RY 20.8% 18.5% 16.2% 17.3% 15.8% 17.6% 23.8% 25.9% 18.7% 16.8% 16.9% 20.8% 19.8% n/a n/a n/a TD 16.2% 17.2% 4.1% 13.0% 18.5% 15.2% 25.3% 19.4% 16.0% 9.8% 13.5% 17.4% 15.4% 14.8% 16.1% 16.5% Median 18.6% 17.0% 10.8% 17.2% 18.7% 17.3% 23.1% 20.7% 16.3% 12.7% 16.9% 20.7% 19.9% 16.7% 16.1% 16.5%

As at fiscal Q3/13. Source: Company reports, RBC Capital Markets estimates

Exhibit 31: Loans have declined relative to shareholders’ equity

Loan Exposure (Annual since 1989)

19x

17x

15x

13x

11x

7x 89 91 93 95 97 99 01 03 05 07 09 11 13

Total Loans / Common Equity Total Loans / Tangible Equity

Total Big Six Banks. Source: Company reports, RBC Capital Markets

The 2003 to 2007 period was a good one for Canadian banks. Loan losses declined from the early 2000s peak, loan growth improved (to about 10% in the 2005–2007 period from -2% in 2003), rising equity markets drove higher wealth management activity, and capital markets businesses were on a growing path. ROE rose to a peak of 23.5% in 2006.

Then came the financial crisis and recession in late 2007, 2008, and early 2009, a period first characterized by liquidity challenges and declining asset values, and then a recession, followed first by a recovery in asset values and then in the economy. There were similarities and differences in how Canadian banks were affected relative to the difficult periods of early 2000s and early 1990s, and there were differences between the Canadian and US experiences. September 18, 2013 48 Canadian Bank Primer, Sixth Edition

Similar to prior slowdowns:  Volatility in bank shares was high. From peak to trough, the Canadian Bank Index declined 58% from its high of 2,143 points reached in May 2007, and then grew 107% in the following year (or recovered to 87% of that peak).  Canadian banks maintained their dividends.  Loan losses rose rapidly.

Different from prior slowdowns:  Banks were more affected by writedowns, which occurred early in the slowdown. The flip side to being less exposed to credit risk than in the past is that banks are more exposed to market risk. Capital markets-related writedowns that were separately disclosed for the Canadian banking industry were $23 billion from 2007 to 2009. While the bulk of writedowns were occurring (from the fourth quarter of 2007 to the first quarter of 2009), loan losses were still fairly low, so capital markets writedowns were offset by profitable retail banking conditions.  The greater exposure to capital markets proved helpful by the time loan losses rose. Loan losses tend to lag an economic recovery while asset values lead; therefore, by the time Canadian banks started feeling the effects of higher credit losses from the weak economy, wholesale divisions were benefiting from attractive trading conditions. For example, specific loan losses jumped in 2009 (from 0.51% in the fourth quarter of 2008 to 0.71% in the first quarter of 2009 and remained close to 0.85% in each quarter for the remainder of 2009), which was also a time when trading revenues were higher than normal (trading revenues were between 9% and 14% of total revenues compared to a median rate of 8% before that).  Retail loan growth remained strong, driven by mortgage lending, which was fuelled in large part by low interest rates. For example, consumer and mortgage lending slowed but was still above 6–7% compared to negative growth in the early 1980s and sub-5% growth in the early to mid-1990s. Business lending slowed drastically, as is normally the case (commercial loan balances have declined in each of the early 1980s, early 1990s, early 2000s, and 2010 credit cycles).  Loan losses were felt more in consumer loan books than in business loan books and were lower than in the prior three credit cycles.  ROE was higher than in prior downturns because loan losses rose less, the increased diversification of revenues, and lower exposure to traditional credit risk proved to be key contributors. The sector’s ROE troughed at 13% in 2009.

Different from the experience of US banks and the US economy:  Job losses in the Canadian economy were fewer than in the US economy, and the recovery came earlier. Using the unemployment rate to make this point, the Canadian unemployment rate was 5.9% at its trough in February 2008, rose 280 basis points to the peak of 8.7% in August 2009, and has since come down to 7.1% (as of August 2013). In the meantime, the US unemployment rate was 4.4% at its trough in May 2007, rose 570 basis points to the peak of 10.1% in October 2009, and has since come down to 7.3% today (Exhibit 32).  The Canadian housing market held up much better than the US market. Prices dipped in late 2008 to early 2009 but increased again until very recently, unlike in the US, Canadian housing prices are near or at peak levels whereas US housing prices are down about 10% from peak levels after having declined much more (Exhibit 32). We discuss the Canadian housing market in greater detail in “SECTION 4: Retail banking is the largest earnings contributor for banks”.

September 18, 2013 49 Canadian Bank Primer, Sixth Edition

 Credit losses rose, but losses as a percentage of loans were lower than in the recessions of the early 1980s, 1990s, and 2000s. This is in contrast to the US banking system’s experience (Exhibit 33).  Writedowns were lower than they were for many global banks with exposure to capital markets.  Reported ROE troughed at just 13% in 2009 compared to negative ROE for US banks (Exhibit 33).  Government involvement in the Canadian banking system was much lower than in the US. The Canadian government helped the banks from a funding perspective during the banking crisis (Insured Mortgage Purchase Program), but there were no capital injections, bailouts, or failures, unlike in the US.  Some but not all Canadian banks raised common equity during the crisis.  Dividends were maintained at all Canadian banks whereas they were cut almost across the board in the US.  Loan growth remained positive for Canadian banks whereas it turned negative for US banks (Exhibit 33).  US banks’ revenues have been pressured by government reviews of credit cards businesses, overdraft fees, and interchange fees. Except for slight changes to credit cards businesses13, Canadian banks have not faced similar pressure on fees in Canada.

As a result of the many differences highlighted above, we expect all but one of the Canadian banks to have higher 2014 earnings per share than at their 2006/2007 peaks. Based on consensus estimates, there are very few US banks in that category (Exhibit 34) and we note that the banks shown in our table are only the ones that have survived the crisis/recession. If including banks that failed or were taken over at low prices, the comparison would be even more striking.

Exhibit 32: Unemployment rates and house prices fared better in Canada than the US in the most recent downturn

Unemployment Rates Existing home sales price (YoY % chg) (Since 1976) (Since 1981) 30% 15% 25%

13% 20%

15% 11% 10%

5% 9%

7% -5%

-10% 5% -15%

3% -20% 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canadian Unemployment Rate U.S. Unemployment rate Canada U.S.

Source: Statistics Canada, US Bureau of Labour Statistics, National Association of Realtors, Canadian Real Estate Association, RBC Economics, RBC Capital Markets

13 New credit card rules in Canada came into effect on September 1, 2010, which had a modestly negative effect on banks, in our view, but not big enough to be separately disclosed. The rules targeted: 1) the allocation of payments on balances having different interest rates (which is now more beneficial for customers than before); 2) a minimum 21-day grace period on making payments after the end of the billing cycle; and 3) a 21-day interest-free period for customers who pay their balance in full (which is in contrast to the general practice of charging interest on all new purchases if a balance was carried in the prior month). September 18, 2013 50 Canadian Bank Primer, Sixth Edition

Exhibit 33: Provisions for credit losses, loan growth, and ROE did not deteriorate as much as in the US

Provisions / Loans Return on Equity - Canada vs. U.S. (Annual since 1977) (Annual since 1970) 30.0% 500 4.0% 500

450 450 3.5% 25.0%

400 400 3.0% 20.0% 350 350

2.5% 15.0% 300 300

2.0% 250 10.0% 250

200 200 1.5% 5.0%

150 150 1.0% 0.0% 100 100 0.5% 50 -5.0% 50 0.0% 0 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 -10.0% 0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 recessions Canadian Banks Provisions as a % of Loans Recessions Canadian Bank ROE U.S. Bank ROE U.S. Banks Provisions as a % of Loans U.S. Banks NCOs as a % of Loans Canadian Loan Growth (YoY) United States - Loan Growth (YoY) (Since 1972) (Since 1972)

40% 25% 25-year Average Loan March 2013 Loan Growth: 25-year Average Most Recent Loan Consumer: 5.8% Consumer: 5.9% Loan Growth: Growth: 20% Mortgages: 7.0% Mortgages: -2.2% 30% Consumer: 8.0% Consumer: 2.2% Commercial: 5.9% Commercial: 6.7% Mortgages: 8.1% Mortgages: 4.9% Commercial: 3.6% Commercial: 12.1% 15% 20%

10% 10%

0% 0%

-10% -5%

-20% -10% 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Consumer Res. Mortgages Commercial Consumer Commercial Res. Mortgages

Canadian credit as of July 2013; US credit as of March 2013. Source: Company reports, Statistics Canada, US Federal Reserve Board, RBC Economics, RBC Capital Markets

September 18, 2013 51 Canadian Bank Primer, Sixth Edition

Exhibit 34: Our Canadian Bank EPS estimates for 2014 are higher than prior peaks for most banks, unlike in the US

Priced as of: 17-Sep-13 Share Price Core cash EPS % change

Date of % change vs. 2014E vs. Canadian Banks Peak Peak Current peak 2006 2007 2012 2013E 2014E Peak '06/'07 Bank of Montreal $72.75 18-Apr-07 $67.12 (8%) $ 5.12 $ 5.52 $ 6.00 $ 6.18 $ 6.45 17% Scotiabank $54.48 17-May-07 $59.80 10% $ 3.56 $ 4.03 $ 4.64 $ 5.15 $ 5.50 37% CIBC $106.75 23-May-07 $81.74 (23%) $ 7.29 $ 8.81 $ 8.07 $ 8.64 $ 8.35 (5)% National Bank $66.59 21-Dec-06 $84.60 27% $ 5.05 $ 5.65 $ 7.86 $ 8.31 $ 8.70 54% Royal Bank $60.62 24-May-07 $65.91 9% $ 3.58 $ 4.20 $ 5.00 n/a n/a n/a TD Bank $76.33 01-Oct-07 $90.79 19% $ 4.70 $ 5.80 $ 7.43 $ 7.52 $ 8.55 47% Median ex RY 10% 37% Canadian Western $31.89 14-Dec-07 $30.97 (3%) $ 1.12 $ 1.45 $ 2.31 $ 2.37 $ 2.75 89% Laurentian Bank $44.69 10-Oct-07 $44.77 0% $ 1.99 $ 2.70 $ 4.99 $ 5.23 $ 5.50 104%

Share Price Operating EPS * % change

Date of % change vs. 2014E vs. U.S. banks Peak Peak Current peak 2006 2007 2012 2013E 2014E Peak '06/'07 Bank of America $54.90 16-Nov-06 $14.55 (73%) 4.59 3.29 0.24 0.94 1.36 (70)% Citigroup $564.10 27-Dec-06 $51.20 (91%) 42.70 6.74 3.43 4.90 5.60 (87)% Goldman Sachs $247.92 31-Oct-07 $167.42 (32%) 19.69 24.73 12.23 15.45 15.51 (37)% JP Morgan $53.20 09-May-07 $53.09 (0%) 4.04 4.33 4.96 5.90 6.10 41% Morgan Stanley $74.13 14-Jun-07 $29.01 (61%) 7.07 2.90 0.78 1.99 2.65 (63)% BB&T $44.63 27-Dec-06 $35.06 (21%) 2.81 3.14 2.72 2.51 3.10 (1)% Fifth Third $48.09 04-Feb-05 $18.55 (61%) 2.13 1.98 1.62 1.95 1.74 (18)% KeyCorp $39.79 22-Feb-07 $12.12 (70%) 2.57 2.32 0.85 0.92 1.00 (61)% SunTrust $90.61 22-May-07 $33.96 (63%) 5.78 4.52 3.50 2.72 2.95 (49)% US Bancorp $37.99 19-Sep-08 $37.52 (1%) 2.61 2.42 2.87 3.01 3.20 23% Wells Fargo $39.80 19-Sep-08 $42.85 8% 2.47 2.38 3.33 3.84 4.00 62% PNC Financial $81.21 19-Sep-08 $74.77 (8%) 8.71 4.32 5.48 6.96 6.95 (20)% M&T Bancorp $124.74 20-Feb-07 $113.54 (9%) 7.37 5.95 7.56 8.69 8.77 19% Median (32%) (20)%

* Consensus operating EPS from SNL; ** Citigroup’s peak share price adjusted up 10x to reflect 10-for-1 reverse stock split on May 9, 2011. Source: Company Reports, ThomsonOne, Bloomberg, SNL, RBC Capital Markets estimates

The economic and banking environment has improved materially since the late-2008 to early-2009 period. Bank ROE in recent quarters have been in the 17–20% range, well up from the troughs of 13% despite holding more capital (Exhibit 36). The improvement in profitability has come primarily from a combination of lower writedowns, declining provisions for credit losses, and improved wealth management results on the back of higher equity markets. We expect ROE of around 16–17% for the industry in 2013 and 2014.

The Canadian banks increased their market share of the Canadian financial services market during and after the financial crisis. Examples of Canadian businesses that were sold by non- domestic owners to a Canadian bank include ING Direct, Ally Financial, AIG Life Insurance, E*TRADE Canada, Citi Cards Canada, MBNA Canada, and HSBC Securities. (Exhibit 43)

While much improved, the macro environment is still fragile and growth is slow. European sovereign, banking, and economic challenges have had a large impact on global risk appetite in the last few years. Our sense is that share price volatility related to European issues could continue for some time in spite of the Canadian banks not having meaningful direct exposure

September 18, 2013 52 Canadian Bank Primer, Sixth Edition

to the more challenged countries (we highlight those in Exhibit 38), as their stocks are indirectly impacted by the market volatility that results from European concerns. North American real GDP growth has recovered from the recession, but, at 2.9% expected in 2014 for Canada and the US, growth remains below averages of 3.3% and 3.1%, respectively, since 1961.

Exhibit 35: Earnings growth is usually greater than 10% or negative

Canadian Bank Index YoY Recurring Earnings Growth (Quarterly since 1988) 40%

30%

20%

10%

-10%

-20%

-30% 88 90 92 94 96 98 00 02 04 06 08 10 12 14E

Shaded area represents recession

Source: RBC Capital Markets Quantitative Research, RBC Capital Markets estimates

Expectations for EPS growth are much lower than in past periods of economic growth, reflecting GDP growth being lower than normal, as highlighted above, loan growth being negatively impacted by the Canadian Government’s efforts to reduce the trend of increasing consumer leverage, and pressure on net interest income margins. We expect core cash EPS growth of 2% in 2013 and 8% in 2014, which are at the low end of growth rates experienced in past periods of economic recovery and below the growth rates of 2010-2012 (8-15%).

Exhibit 36: ROE has improved since 2009 despite banks holding more capital

Return on Equity vs. Tier 1 Common Ratio/Common Equity Tier 1 Ratio* (Since 2005) 11% 25%

10% 21%

9% 17%

8% 13%

7% 9%

6% 5% 4Q05 2Q06 4Q06 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09 2Q10 4Q10 2Q11 4Q11 2Q12 4Q12 2Q13

Tier 1 common ratio / Common equity Tier 1 ratio (LHS) Cash ROE (RHS)

* Basel III common equity Tier 1 ratio beginning in Q1/13. Source: Company Reports, ThomsonOne, RBC Capital Markets September 18, 2013 53 Canadian Bank Primer, Sixth Edition

Exhibit 37: GDP growth has recently since 2009 but still slightly below average

Quarterly Real Gross Domestic Product (Since 1970) Correlation Coefficient: 0.67 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% -1% -2% -3% -4% -5% -6% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Real GDP Growth YoY (Canada) Real GDP Growth YoY (U.S.)

Annual percentage growth rate of GDP at market prices based on constant local currency Source: World Bank, RBC Capital Markets

Exhibit 38: Canadian banks’ direct exposures to European periphery is small

Europe Exposures

A,B ($ millions) BMO BNS CM NA TD

Estimated Total Europe (Gross) 1 24,084 28,467 14,092 2,452 42,459 Estimated % of Tier 1 common (gross) 119% 119% 115% 49% 172% Estimated Total Europe (Net) 2 10,881 n/a n/a 1,063 35,492 Estimated % of Tier 1 common (net) 54% n/a n/a 21% 144% Estimated Total Europe (Net and Excluding Future Potential Exposure) 3 7,981 n/a 5,485 687 28,471 Estimated % of Tier 1 common (Net and Excluding future potential exposure) 40% n/a 45% 14% 115%

Source: Company Reports, RBC Capital Markets Estimates

Gross exposures include lending commitments (drawn and undrawn), repos net of collateral, OTC derivatives (including potential future exposures), securities (including Trading securities, except for CM) and other exposures unless otherwise noted. They also include deposits held at central banks to support foreign subsidiary operations. TD's repos were adjusted for ~$30 billion of collateral. The following amounts related to trading securities (net of short positions) are included in gross exposure: BMO (n/a), BNS (n/a), CM (n/a), NA ($72 million) and TD ($21.8 billion). 2. Net exposures are adjusted for collateral and include undrawn commitments and future potential exposure unless otherwise noted. Purchased credit protection is not included. The following adjustments have been made to be consistent with other banks. BMO's net exposure includes $2.9 billion of potential future credit exposure. NA's net exposure includes an estimated $324 million in future potential exposure. 3. Net Exposure excluding future potential exposure uses the mark-to- market (MTM) exposure net of collateral for OTC derivatives (i.e. Ignores future potential exposure). We estimate TD's OTC mark-to-market exposure net of collateral at ~$1 billion. (A) In addition to the table above, BMO also has exposures to European countries via its credit protection vehicle, US customer securitization vehicle and structured investment vehicles. Please see page 22 of their Q1/2013 Report to Shareholders for further detail. (B) To be consistent with other banks, BMO's lending commitments (drawn and undrawn) include $80 million related to required reserves at the Irish central bank to support the Irish subsidiary.

Geographic Mix of European Exposure Periphery U.K., Germany and France Rest of Europe Total

BMO 1 1% 37% 62% 100%

BNS 2 7% 65% 28% 100%

CM 3 0% 64% 36% 100%

NA 4 30% 70% 100% 5 TD 2% 58% 40% 100%

(1) Based on reported net exposure of $7,404 million; (2) Based on reported gross exposure of $19,677 million (funded) and $8,790 million (unfunded); (3) Based on net exposure of $5,485 million reported by company; (4) Based on net exposure of US$615 million. National Bank’s Periphery exposure is largely due to a large Spanish bank exposure that relates to performance guarantees in the trade finance business as the bank has an activity of supporting Canadian exporters and also supporting projects that are ongoing in Canada that may require a Canadian bank to provide a letter of guarantee. Management indicated that those are performance guarantees so they have a nature of double default, and in order for the bank to have exposure to the Spanish bank, there would need to be a problem in the project first, then a problem with the Spanish bank. (5) Based on reported net exposure of $35,492 million.

Continued on next page September 18, 2013 54 Canadian Bank Primer, Sixth Edition

Guide for readers The following will help readers follow the exhibit above on European exposures. There is, unfortunately, no standard methodology for the disclosure of exposures to Europe so making apples to apples comparisons is difficult. Exposures to European banks, sovereigns and corporations generally come from (1) loans and acceptances, (2) securities, (3) letters of credit and guarantees, (4) repo style transactions, and (5) over the counter derivatives. Investors generally think of European exposures in three “buckets”: (1) periphery countries— Greece, Ireland, Italy, Portugal, and Spain; (2) UK, Germany, and France; and (3) the rest of Europe. Unfortunately, the measurement of the exposures is not always disclosed consistently, and neither is the geographic breakup.

 Loans and acceptances are split between drawn and undrawn commitments. There is no debate on drawn loans being counted. Undrawn commitments are not exposures that the banks have today, but they might become exposures in the future.  Securities categorized as available for sale as well as those categorized as trading securities should be included in exposures, although under the Basel II framework, trading securities are included in market risk calculations rather than structural banking books, so one must be careful that banks are including both types of securities in their disclosures.  Letters of credit and guarantees are not exposures that the banks have today but they might become exposures in the future.  Exposures from repo style transactions occur when a bank has advanced funding to another institution with the other institution pledging collateral to guarantee that funding. Banks wind up having large gross exposures to counterparties but the exposure net of collateral is significantly smaller. The nature of the collateral is generally not disclosed but it will usually be of higher quality than the counterparty bank’s credit rating. i.e., the collateral provided by a counterparty bank might be US, UK, or German bonds. We prefer having the disclosures on both a gross and net basis, but if we had a choice, we think that the exposure is better measured on a net basis.  Disclosures on derivative transactions have three “layers”. (1) Fair value of derivatives refers to how much a banks is owed from a counterparty as at a certain date from derivatives transactions. A bank would be owed money if the derivatives it held were in a profitable position. (2) Derivatives can also be calculated under a framework similar to the regulatory framework whereby an amount for future credit exposure is added to the fair value to measure the potential future movements in derivative values, which would impact how much banks could be owed at a future date. (3) Collateral is provided against fair value exposures to protect under against a failing counterparty, which we believe investors should net against the gross exposures. Because banks do not disclose their exposures on a consistent basis given the debate on how to properly measure it, investors must be cautious in comparing headline figures provided by banks. We have attempted to provide a summary of the disclosures on a basis that is as comparable as can be.

 We first show gross exposure, which we define as including all lending commitments (i.e., including undrawn), all types of securities, derivatives including future exposures and ignoring collateral. For repos, we calculate gross exposure net of collateral.  We then show net exposures, which we define as the gross exposures minus collateral held in derivatives transactions.  We show the net exposure with the gross derivatives exposure defined as fair market value (i.e., without the future credit exposure add-on).  Lastly, we show the net exposure with the derivatives exposure defined as fair market value (i.e. without the future credit exposure add-on) net of collateral.

Source: Company Reports, RBC Capital Markets Estimates

September 18, 2013 55 Canadian Bank Primer, Sixth Edition

Canadian banks’ profiles have changed dramatically in the last two decades, generally in ways that make them more profitable, which has led to higher valuation multiples. Banks’ profitability and capital positions are still exposed to swings in the economy and capital markets, but we believe that the banks are in better positions than 20 years ago to handle those swings.

 ROE has expanded to around 17–18% during the 2000s from nearly 10% during the 1980s and reached more than 20% in 2006–2007 (Exhibit 36).  Capitalization has strengthened and the quality of capital has improved with the implementation of Basel III in 2013. Canadian banks are now required to meet a minimum common equity Tier 1 ratio of 8% (including a 1% buffer for domestically systemically important banks). Tier 1 ratios have increased to more than 12% from 5% under much more stringent definitions of capital and risk weighted assets. Higher ROE and higher capitalization is a generally good recipe for higher valuation multiples (Exhibit 36).

Exhibit 39: Risk-adjusted capital ratios have risen in the last two decades

Bank Capital Ratios (Annual since 1988)

16%

14%

12%

10%

4% 88 90 92 94 96 98 00 02 04 06 08 10 12 14E

Tangible Common Equity as % of RWA Common Equity % RWA Tier 1 Capital Ratio Tier 1 common / RWA Basel III pro forma common equity Tier 1 ratio

Median Big Six Banks. Risk-weighted assets are calculated using Basel II (Q1/08-Q4/12) and Basel III since Q1/13. Source: Company reports, RBC Capital Markets estimates

 Canadian banks became less exposed to traditional credit risk because of: 1) less exposure to loans; and 2) less exposure to corporate lending, in particular. We believe that the lower exposure to traditional credit risk will lead to higher trough ROE in economic slowdowns (Exhibit 40).  Cycles, however, might be longer because banks’ securities are likely to decline in value ahead of losses being realized in their loan books. Losses on securities and other capital markets-related exposures in the recent financial crisis led to banks incurring losses ahead of the economy weakening and banks’ subsequent loan losses, which was not a dynamic that was present in the early 1990s.  The positive aspect of being more exposed to securities but less exposed to loans is that the bluntness of the latest cycle was less acute because banks first took hits on securities and few hits on loans. The reverse then happened. Said differently, banks are less exposed to the credit stage of pain than they were in the early 1990s, when the industry’s ROE slipped to 5%.

September 18, 2013 56 Canadian Bank Primer, Sixth Edition

 They grew in areas outside lending, particularly capital markets and wealth management, thereby decreasing their dependence on spread income (which is directionally positive for ROE but also an important offset to loan losses in weaker economic periods because loan losses lag the economy, and wealth management and capital markets revenues might be more coincidental with economic changes or even leading in some cases). Generally, buoyant equity and capital markets helped fuel that growth, as well as acquisitions (Exhibit 41).

Exhibit 40: Loans represent smaller proportion of balance sheet vs. 1970-1995*; business loan mix has declined

Loan Mix Gross Loans as % of Total Assets (Annual since 1983) (Annual since 1970) 80% 80%

70%

70% 60%

50% 60% 40%

50% 30%

20%

40% 10%

0% 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 30% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14E Total Retail Loans as % Total Loans Mortgages as % Total Loans Gross Loans as % of Total Assets Retail Non Mtg as % Total Loans Business and Government Loans

* Canadian banks adopted IFRS as of 2011, which brought securitized loans back on balance sheet. Total Big Six Banks. Source: Company reports, RBC Capital Markets estimates

Exhibit 41: Revenues became less dependent on net interest income until late 1990’s

Market Sensitive Revenue % of Total Revenue* vs. SPTSX Growth Bank Revenue Breakdown (Quarterly since 2000) (Annual Since 1980) Correlation Coefficient: 0.44 90% 50%

80% 40%

70% 30%

60% 53.4% 20% 50% 46.6% 10% 40% 0% 30% -10% 20%

-20% 10%

0% -30% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13

Non-Interest Income as % Total Revenue Net Interest Income as % Total Revenue Market Sensitive Revenue % of Total Revenue SPTSX Index Average QoQ Growth

* Includes special items. Median of Big Six Banks (includes underwriting, advisory, brokerage, trading, mutual fund, and investment securities revenues). Source: Bloomberg, Company reports, RBC Capital Markets

 Their funding profiles changed and became more dependent on wholesale funds, which is negative because wholesale funding is normally more expensive and volatile than retail funding (Exhibit 42).

September 18, 2013 57 Canadian Bank Primer, Sixth Edition

Exhibit 42: Personal deposits have declined relative to retail loans*

Personal Deposits as % of Retail Loans Personal Deposits as % of Total Loans (Annual since 1986) (Annual since 1986) 25% 65% 25%

150%

20% 60% 21% 130%

15% 55% 17% 110%

10% 50% 13% 90%

45% 9% 70% 5%

40% 5% 50% 0% 86 88 90 92 94 96 98 00 02 04 06 08 10 12 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Personal Deposits % Retail Loans (LHS) Securitized Assets as % Retail loans (RHS) Personal Deposits % Total Loans (LHS) Securitized Assets as % Loans (RHS)

* Canadian banks adopted IFRS as of 2011, which brought securitized loans back on balance sheet. Total Big Six Banks includes international deposits and international retail loans. Source: Company reports, RBC Capital Markets

Valuation multiples rose in the 20 years leading to 2007, which reflected the banks’ higher ROE, declining exposure to traditional credit risk, stronger capitalization, and a near-ideal macro environment (low and declining long-term interest rates, benign inflation, and generally buoyant equity and capital markets activity).

 Bank stocks were good investments with growing earnings and book values, combined with expanding valuation multiples. In the 22 years from 1988 to 2010, the Canadian Bank Index total return was negative in only six years (1990, 1992, 1998, 1999, 2007, and 2008), and the worst down year was -31% in 2008. Relative to the S&P/TSX Composite Index, banks outperformed in 19 of the last 23 years (Exhibit 18).

Valuation multiples declined from 2007 to early 2009 and recovered in 2010.  While Canadian bank stocks were outperformers relative to their global peers, 2008 and early 2009 were not pleasant years for Canadian bank shareholders on an absolute basis. Valuation multiples declined as investors grew concerned about: 1) capital markets- related exposures including off balance sheet commitments; 2) a very rapid slowdown in the world economy in late 2008, which introduced uncertainty over potential loan losses; and 3) the cost and availability of wholesale funding.  After the trough in bank valuations in February 2009, bank share prices spiked, and the Bank Index total return was up more than the S&P/TSX Composite Index in 2009 (63% compared to 35%), driven by an improved economic outlook and valuations of debt (and equity) securities, which lowered the prospects of writedowns, improved economic prospects, strong trading and underwriting results, improved capital ratios, and surprisingly resilient loan growth in Canada. In 2010, the Bank Index return underperformed the Composite Index (11% compared to 18%), partly due to the strength of the energy and commodities sectors in 2010.

Valuation multiples have since been volatile for bank stocks and equity markets in general, in large part due to the fragile macro environment, worries over the Canadian housing market and slow growth as discussed earlier. Bank valuations have been at the low end of their 15-year range.

September 18, 2013 58 Canadian Bank Primer, Sixth Edition

 Canadian bank stocks were up 15% in 2012, faring better than the S&P/TSX Composite Index (up 5%), but under performing the life insurance stocks (up 56%) and the US bank index (up 52%).  We believe that bank stocks could provide total returns in the 8-21% range over the next year. We believe that current bank valuations already reflect modest expected growth in earnings, while book value growth and dividend yields are attractive. We do not expect material multiple compression, short of bouts of risk aversion or the market expecting a recession, while there is modest upside to multiples in a healthier economic growth environment. We expect the sector to grow EPS at 6% in 2015 over 2014, and book value at ~10% in the next 12 months. Dividend yields are currently ~3.8-4.7%.

Banks consolidated most areas of retail financial services (insurance being the exception) and capital markets.  In the last two decades, banks increased their retail presence (particularly mortgages and deposits), mostly by buying most trust companies. Canada Trust (TD), Central Guaranty Trust (TD), Montreal Trust (Scotiabank), National Trust (Scotiabank), Royal Trust (Royal Bank), and Trust General (National Bank) were all acquired by the Big Six Canadian Banks. TD’s acquisition of Canada Trust in 2000 was the largest at $8 billion. Some Canadian banks have also acquired Canadian books of business from existing foreign competitors such as Royal Bank’s acquisition of Ally Financial Canada in 2012, Scotiabank’s acquisition of ING Direct Canada in 2012, TD’s acquisition of MBNA Canada in 2011, CIBC’s acquisitions of Citigroup’s Canadian MasterCard portfolio as well as CIT Business Credit Canada in 2010.  Canadian banks’ capital markets and retail-brokerage businesses were also enhanced by acquisitions. TD Bank bought Newcrest; Royal Bank bought Dominion Securities and Richardson Greenshields; National Bank bought Levesque, Beaubien, Geoffrion, and First Marathon, as well as Wellington West in 2011 and HSBC Canada’s retail brokerage in 2012; Scotiabank bought McLeod, Young, Weir as well as E*Trade Canada; Bank of` Montreal bought Nesbitt Burns; and CIBC bought Wood Gundy and businesses from Merrill Lynch twice.  There have been some asset management-driven acquisitions as well, with CIBC purchasing TAL and a 41% stake in American Century, Royal Bank buying Phillips Hager and North, Bank of Montreal acquiring Guardian Group of Funds, National Bank buying Altamira, and Scotiabank buying DundeeWealth as well as a stake in CI Financial. National Bank has since sold Natcan Investment Management to Fiera Capital Corporation in return for a 35% stake in Fiera (or 40% if options are fully exercised).  Banks have also attempted to merge, but those attempts were thwarted by the government. In 1998, the Minister of Finance turned down the proposed mergers between Royal Bank and the Bank of Montreal and also between CIBC and TD. It was widely reported, but never officially confirmed, that Bank of Montreal and Scotiabank had a merger proposal denied by the government in 2002. No formal political position for or against bank mergers has been established since.  The broadening of banks’ offerings beyond traditional banking products is, in our view, positive for customer retention and makes it more difficult for new entrants to come to Canada. A customer that once had a mortgage, a credit card, and chequing and savings accounts might now also have a home equity line of credit, mutual funds, a full- service and/or discount-brokerage account, and might be receiving and paying bills electronically via their bank. The more products a customer has with a financial institution, the more difficult it is to switch institutions. Furthermore, we believe it is very difficult for a new entrant to replicate the full-service offering that the larger Canadian banks offer.

September 18, 2013 59 Canadian Bank Primer, Sixth Edition

Forays outside Canada sped up after mergers failed and consolidation opportunities in Canada dwindled. The banks generated excess capital for most of the last decade, even after paying dividends and buying back shares. Returns on acquisitions so far have generally been sub-par in our view, except in the case of Scotiabank. We highlight the most significant non- domestic acquisitions below and in Exhibit 43:

 TD has invested $21 billion since 2005 to build a US retail banking presence, led by the acquisitions of Banknorth and Commerce Bancorp. The most recent deals included the acquisition of Target’s US credit card business, Chrysler Financial, the FDIC-assisted acquisition of Riverside National Bank, and the non-FDIC assisted acquisition of The South Financial Group (allocated goodwill for these acquisitions total approximately $0.6 billion). Returns on US banking acquisitions have been low in a difficult operating environment, with US banking earnings of $1.6 billion in the 12 months ended for the third quarter of 2012, implying a return of 7% on the $21 billion invested. TD also purchased Waterhouse Investor Services in 1996 for $525 million, an acquisition that has proved very successful and recently purchased Epoch Investment Partners a US based investment management firm for US$668 million.  Royal Bank had invested $7 billion in US retail banking acquisitions since 2000 but then sold its US retail banking operations to the PNC Financial Services Group in March 2012 for approximately US$3.6 billion, and also sold its US life insurance company for US$0.6 billion. Returns from the US banking acquisitions had been negative in the years before the sale in a difficult operating environment, with a net loss in the discontinued operations of nearly $240 million in 2011 and a loss of $390 million in 2010. Royal Bank also purchased the other half of its RBC Dexia joint venture (for $1.1 billion), Blue Bay Asset Management (in the UK for $1.6 billion), RBTT (Caribbean banking for $2.3 billion), Dain Rauscher and Tucker Anthony Sutro (US capital markets and wealth management for $2.8 billion), and Liberty Insurance Services ($0.9 billion), which it has since sold.  CIBC acquired a 41% stake in American Century for US$848 million in 2011. It also acquired Citigroup’s Canadian MasterCard portfolio in September 2010 and CIT Financial’s 50% stake in Canadian business credit that CIBC did not already own. The bank also bought a 22% stake in the Bank of N.T. Butterfield & Son Limited in the Caribbean for $150 million. In 2007, it acquired the stake of its former partner Barclays in FirstCaribbean for $2.3 billion, and it bought Oppenheimer Holdings in 1997 for about $500 million (which it has since sold).  Bank of Montreal closed its acquisition of Marshall & Ilsley (M&I) in July 2011 for US$4.1 billion, the largest acquisition in the bank’s history. It had also made numerous small acquisitions in its Chicago-land and Milwaukee footprint, with one sizeable acquisition (CSFBdirect in 2002 for $850 million) later sold for a small gain. In 2009, the bank purchased the North American franchise of the Diners Club credit card for $840 million.  Scotiabank has been an active consolidator of banks in Latin America and in Asia in recent years. Most acquisitions have been sub-$500 million, except for Banco Colpatria for $1 billion in 2011, Siam City Bank (for a contribution of $650 million in 2009), Inverlat (a total of $785 million in 2000 and 2003), and the 2007 acquisition of Banco del Desarrollo in Chile ($1 billion). In 2010, the bank also closed the FDIC-assisted acquisition of R-G Premier Bank of Puerto Rico for a contribution of $460 million.

We expect acquisitions outside Canada to continue because:  The Canadian financial market is largely consolidated, leaving few opportunities for banks to make meaningful acquisitions.  Canadian retail lending is unlikely to be fuelled by an increase in leverage as it was for most of the 2000s, and as such, slower retail-loan growth should be expected (Exhibit 29). September 18, 2013 60 Canadian Bank Primer, Sixth Edition

 Canadian banks have strong capital positions under new Basel III rules.  The Canadian dollar has appreciated in the last decade.  The Canadian banks have bigger non-domestic franchises to lever in making acquisitions than they used to have.  Opportunities abroad have increased as financial institutions globally continue to deleverage or review businesses and find some portfolios are not core to their strategies.

The Canadian banks have improved their capital ratios since 2007 which, combined with greater clarity on regulatory capital rules, now positions the banks to return capital to shareholders and/or use more cash when pursuing acquisitions, thereby increasing accretion to earnings per share. Basel III common equity Tier 1 ratios for the Big Six banks now range from 8.6% at National Bank to 9.6% at Bank of Montreal. OSFI’s required minimum is 8.0%, which includes a 1% domestic systematically important bank (D-SIB) buffer. Canadian banks historically have had capital ratios in excess of minimum OSFI targets, and we think a 0.5-1.0% cushion is reflective of what banks in general might target. CIBC, Bank of Montreal and Royal Bank are currently over 9.0% already, whereas we expect the other three large cap banks we cover to reach that level by the second half of 2014. We discuss our views on capital, including dividend increases, balance sheet optimization, and other capital deployment in “SECTION 8: Capital supports both expected and unexpected risks”.

September 18, 2013 61 Canadian Bank Primer, Sixth Edition

Exhibit 43: Canadian bank acquisitions since 2000

Purchase Purchase Price Price Closing ($ Closing ($ Year Date Target millions) Year Date Target millions) BMO RY 2011 5-Jul Marshall & Ilsley Corporation $4,018 2013 1-Feb Ally's Canadian automotive finance business $3,700 2010 23-Apr AMCORE Bank $225 2012 27-Jul RBC Dexia (other half of 50/50 joint venture) C$1,100 2009 31-Dec Diners Club (North American franchise) $840 2010 17-Dec Blue Bay Asset Management C$1,560 2009 1-Apr AIG Life Insurance Company of Canada $280 2008 16-Jun RBTT $2,281 2008 3-Mar Ozaukee Bank $190 2008 20-Jun Ferris Baker Watts $265 2008 3-Mar Merchants and Manufacturers $137 2008 1-May Phillips, Hager & North $1,297 2007 4-Jan First National Bank & Trust $345 2008 22-Feb Alabama National $1,775 2004 30-Dec Mercantile Bancorp Inc. $194 2007 9-Mar AmSouth Branches $405 2004 4-Jun New Lenox State Bank $314 2006 8-Dec Flag $498 2002 26-Jul Morgan Stanley Online Accounts $153 2005 30-Nov Abacus Wealth Mangement $213 2002 4-Feb CSFB direct $854 2004 27-Feb William R. Hough $150 2001 13-Jul First National Bank of Joliet, $337 2003 21-Nov Provident $105 2001 19-Jul Guardian Group of Funds Ltd $187 2003 30-Sep SCMC $136 Total $8,074 2003 1-May BMA $296 BNS 2003 29-Jan Admiralty $233 2012 15-Nov ING Direct Canada $3,126 2002 22-Jul Eagle Bancshares $235 2012 17-Jan Banco Colpatria (Colombia) $1,000 2002 28-Jun Barclays (private banking assets in the Americas) $169 2011 1-Feb DundeeWealth Inc. $2,300 2001 31-Oct Tucker Anthony Sutro $943 2010 3-Feb R-G Premier Bank of Puerto Rico $460 2001 5-Jun Centura $3,331 2009 9-Apr Siam City Bank (acquired by Thanachart Bank) $650 * 2001 10-Jan Dain Rauscher $1,838 2009 3-Feb Thanachart Bank (additional 24% to 49%) $270 2000 1-Nov Liberty $890 2008 2H08 Scotiabank Peru (additional 20% to 98%) $230 Total $18,760 2008 6-Oct CI Financial Income Fund (38%) $2,300 TD 2008 22-Sep E*Trade Canada $422 2013 27-Mar Epoch Invesmtent Partners $668 2007 28-Sep Dundee Bank of Canada $260 2013 13-Mar Target's U.S. credit card portfolio $98 2007 26-Nov Banco del Desarrolo (Chile) $1,000 2011 1-Dec MBNA Canada $540 2007 29-Mar Thanachart Bank (24.99%) $240 2011 1-Apr Chrysler Financial $242 2006 31-Mar National Bank of Greece (CDN Ops.) $306 2010 30-Sep The South Financial Group, Inc $199 2006 1-Sep Corporacion Interfin (Costa Rica) $325 2010 16-Apr Riverside National Bank of Florida $196 2006 9-Mar 2 Peruvian Banks $385 2008 31-Mar Commerce Bancorp Inc. $8,508 2003 30-Apr Grupo Financiero Scotiabank Inverlat $465 2007 1-Jan Interchange Financial Services Corp $545 2000 30-Nov Inverlat $320 2007 20-Apr Completion of TD Banknorth privatization $3,700 Total $14,059 2006 31-Jan Hudson United Bancorp $2,200 CM 2006 15-May VFC $328 2013 11-Apr Atlantic Trust Private Wealth Management $210 2005 1-Mar TD Banknorth $5,100 2011 31-Aug American Century (41% stake) $831 2001 26-Nov Outstanding Waterhouse shares $605 2010 1-Sep Citi Cards Canada Inc.'s MasterCard portfolio $1,200 2001 1-Nov R.J. Thompson Holdings $122 2010 30-Apr CIT Business Credit Canada Inc $306 2000 1-Nov Newcrest Holdings $225 2010 2-Mar The Bank of N.T. Butterfield & Son Limited (22% stake) $150 2000 1-Feb Canada Trust $7,998 2007 2-Feb First Caribbean $2,253 Total $31,176 2002 1-Mar Juniper Financial Corp. $310 2002 1-Jan Merrill Lynch Asset Management $559 2001 1-Oct TAL Asset Management $321 Total $6,140 NA 2013 Announced TD Waterhouse Institutional Services $250 2012 1-Jan HSBC Securities Canada Inc. (Retail Brokerage) $105 2011 15-Jul Wellington West Holdings Inc. $273 2006-2008 Credigy Ltd. and 4 investment management firms $171 2002 12-Aug Altamira $263 1999 13-Aug First Marathon Inc. (Brokerage) $654 Total $1,716

List includes acquisitions with disclosed purchase price greater than $90illion. Some acquisitions have since been divested including Royal Bank’s US retail banking franchise and Bank of Montreal’s CSFB direct. * Scotiabank subscribed to additional shares in Thanachart Bank of $650 million as part of financing the Siam City acquisition and contributed $460 million of capital in Scotiabank de Puerto Rico. Source: Company reports, RBC Capital Markets

September 18, 2013 62 Canadian Bank Primer, Sixth Edition

Accounting practices have evolved through the last few decades, with the most recent development being the 2012 conversion from Canadian GAAP (CGAAP) to IFRS. The following is a summary of the main impacts of IFRS conversion on Canadian banks in 2012. For greater detail, please see our report “Canadian Banks: IFRS Impacts”, published February 9, 2012, or our Canadian Bank Primer, Fourth Edition, published August 16, 2011, on page 193. Canadian banks converted to IFRS in fiscal 2012, which led to higher balance sheet leverage and reduced book values and capital ratios. 2011 adjusted EPS under IFRS were within a range of -3% to +2% versus Canadian GAAP, but since the differences between IFRS and CGAAP results were not all recurring, we believe that adjusted EPS under IFRS would generally have been flat to 2% higher than CGAAP excluding non-recurring items.

September 18, 2013 63 Canadian Bank Primer, Sixth Edition

SECTION 4: Retail banking is the largest earnings contributor Retail banking operations consist of branch banking and online banking, with products including mortgages, credit cards, lines of credit, term loans, and deposits (transaction and savings). Small business and commercial operations are generally also considered to be part of retail banking, while financial planning activities are mostly reported in wealth management divisions14, but much of the activity takes place in the banks’ branch networks. Retail banking businesses account for about 50–70% of the banks’ income.

 The Canadian banks’ retail businesses reach customers via many touch points, including branches, online banking, mobile banking, telephone banking, call centres, and mobile sales forces (particularly in areas such as mortgages and investments). The scope of the banks’ distribution infrastructure and the strength of their brands have created significant barriers to entry for competitors in retail financial services.  The Big Six Banks offer similar products, but they try to differentiate themselves by offering innovative products (mobile payments, rewards on debit or credit cards, etc.) or promising a better customer experience and/or more convenient hours and branch locations. Banks compete for market share by extending branch networks and hours, advertising and promotions, and cross-selling products to existing clients. They occasionally compete on price to gain market share, but this is usually short-lived due to the drag on net interest income margins and competition often follows.  Canadian banks also offer insurance products, and for three banks (TD Bank, Royal Bank and Bank of Montreal), insurance is a significant business even though it has not been fully integrated into the retail branch network. Despite relentless lobbying, regulatory and public policymakers have resisted requests from the banks to offer a full line of insurance products in their branches. Most banks offer creditor life, travel, and mortgage insurance to customers in their branches, and some also provide home and auto, as well as life insurance through call centres, direct mail marketing, and insurance- focused offices.  Investors generally prefer banks with stronger retail operations given the high returns and lower volatility of that line of business relative to wholesale banking.

The main factor affecting growth in retail banking earnings is the state of the overall economy. In a good economy, loan growth is more rapid and loan losses are lower. The banks generate approximately 70–75% of their retail banking revenues from net interest income (a function of the size of loan books and margins earned on those loans). Net interest income accounts for 70–75% of retail revenues Loans to individuals make up approximately 75% of the banks’ total loan portfolios held on balance sheets (which includes most securitized loans under IFRS), with residential mortgages making up 48% and personal loans 27%. Personal loans consist of credit card loans, lines of credit (secured and unsecured), car loans, and term loans, and include some small-business loans that are managed on a pooled basis for some banks. Based on Investor Economics data, we estimate that mortgage loans represent about two-thirds of household

14 Some banks allocate distribution fees to the retail banking division while investment management fees are reported in the wealth management division. September 18, 2013 64 Canadian Bank Primer, Sixth Edition

debt while home equity lines of credit15 represent approximately another 11%, instalment loans account for about 11% of household debt, credit cards 6%, and personal lines of credit 4%.

Employment growth, GDP growth, and appreciation in housing prices are good indicators of growth in mortgage balances, while employment growth, GDP growth, and disposable income can be used as indicators for personal lending (Exhibit 44, 46, and 47). Retail lending also includes small business and commercial lending, but the banks’ disclosures make it difficult to single out those loans (they are included in “business lending”, some of which is booked in wholesale divisions and some in retail divisions). For banks that have disclosed details, business loans make up about 15–20% of their Canadian retail loans.

Exhibit 44: Employment growth and house price appreciation have been useful in predicting mortgage lending growth

Canadian Consumer Credit vs. House Price Growth Canadian Mortgage Credit vs. Employment Growth (Since 1989) (Since 1972) Correlation Coefficient: 0.52 Correlation Coefficient: 0.29 30% 10% 16% 25%

20% 14% 25% 7% 15% 12% 20% 10%

10% 4% 5% 15%

8% 0% 10% 1% -5% 6%

5% -10% 4% -2% -15% 0% 2% -20% -5% -5% 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 0% -25% 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Residential Mortgage Credit YoY Growth (LHS) Employment YoY Change (RHS) Consumer Credit YoY Growth (LHS) House Price YoY Change (RHS)

Source: RBC Economics, RBC Capital Markets

15 The HELOC market in Canada has not been used as aggressively as it was in some instances in the US We believe that banks’ HELOC customers that also have a mortgage overwhelmingly (90%+) have the mortgage and the HELOC with the same institution. Also, banks are subject to the 80% LTV constraint for uninsured real estate secured credit, which includes credit related to HELOCs, with OSFI requiring a 65% LTV cap on non-amortizing HELOCs. To be clear, it would still be acceptable to have a combination of a mortgage and HELOC to aggregate to 80% LTV, but a stand- alone HELOC would be limited to 65% LTV. September 18, 2013 65 Canadian Bank Primer, Sixth Edition

Exhibit 45: Growth in employment and personal disposable income are good indicators of growth in personal lending

Canadian Consumer Credit vs. Employment Growth Canadian Consumer Credit vs. Personal Disposable Income (Since 1972) (Since 1992) Correlation Coefficient: 0.73 Correlation Coefficient: 0.49 25% 8% 16% 16%

20% 6% 12% 12%

15% 4% 8% 8%

10% 2% 4% 4%

5% 0%

0% 0% 0% -2%

-4% -4% -5% -4% 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Consumer Credit YoY Change (LHS) Personal Disposable Income YoY Change (RHS) Consumer Credit YoY Change (LHS) Canadian Employment YoY Change (RHS)

Source: RBC Economics, RBC Capital Markets

Exhibit 46: Real GDP growth is a good predictor of growth in consumer and mortgage credit

Canadian Consumer Credit vs. GDP Canadian Mortgage Credit vs. GDP Growth (Since 1972) (Since 1972) Correlation Coefficient: 0.54 25% 12% Correlation Coefficient: 0.33 25% 15%

20% 9% 20% 11%

15% 6%

15% 7%

10% 3%

10% 3% 5% 0%

5% -1% 0% -3%

-5% -6% 0% -5% 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 72 75 78 81 84 87 90 93 96 99 02 05 08 11

Residential Mortgage Credit YoY Growth (LHS) GDP YoY Change (RHS) Consumer Credit YoY Growth (LHS) Real GDP YoY Growth

Source: RBC Economics, RBC Capital Markets

 Residential mortgage credit outstanding grew at a 10% annual compounded growth rate since 1970 (7% since 1990), peaking at 23% in 1974, and troughed at -1% in 1982. Mortgage growth tends to be stronger when employment and GDP growth are positive, and when housing markets are stronger (i.e., when price appreciation is greater, starts are rising, and sales activity is higher). The most recent year-over-year growth rate in residential mortgages was 4.9% in the 12-months ended June 2013, down from 8.0% in October 2011 and from 13.0% in June 2008.  We expect growth in Canadian mortgage lending to decline from the current ~5% level to the 2–3% range as rising consumer leverage (which grew significantly faster than the growth in personal disposable income in the past decade) is unlikely to be a key driver of mortgage loan growth as it had in the past. We believe that the changes implemented by OSFI in 2012 around HELOCs16

16 OSFI’s guideline for prudent residential mortgage underwriting practices and procedures was published in June 2012. OSFI’s guideline supplements the Financial Stability Board’s Principles for Sound Residential Mortgage Underwriting published on April 18 2012. For greater detail on the OSFI guideline, please see the sub-section below, “Mortgages and credit cards are key retail lending products”. September 18, 2013 66 Canadian Bank Primer, Sixth Edition

(particularly limiting HELOC LTVs to 65% and stricter underwriting guidelines for self-employed borrowers) and by the Canadian Government17 over the past five years (on the type of mortgages they insure and usage of CMHC’s securitization program) have helped reduce the rate of household credit growth. In our view, further changes by the Canadian government and/or OSFI could be introduced if mortgage loan growth remains ahead of personal disposable income (currently ~3%). Furthermore, mortgage affordability remains at the high end of normal ranges, but it could move above normal ranges if employment gains ebbed and/or interest rates rose. Deteriorating affordability would lead to slower loan growth, in our view (Exhibit 47).  Annual growth in personal loans has averaged 9% since 1970 (7% since 1990), peaking at 22% in 1973 and troughed at -4% in 1982. Loan growth tends to be strongest in periods of rising employment and personal disposable income, as well as in periods of increasing consumer leverage. The most recent year-over-year growth rate in consumer lending was 2.2% (12 months ended June 2013), down from 3.0% in the prior year and down from 10.0% in June 2010 (Exhibit 48).  Consumers are generally less sensitive to interest rates in personal lending than in mortgage lending, so changes in personal loan growth are usually heavily influenced by employment growth. We expect the HELOC component of personal lending to be more rate-sensitive than other personal lending categories and also affected by any regulatory or government changes, and therefore, loan growth might be weaker than anticipated by looking solely at personable disposable income growth.

Exhibit 47: Canadian housing affordability remains at the high end of normal ranges

Housing Affordability (Since 1985) 100%

90%

80%

70%

60% bungalow 50%

40%

tax income required to serviceto requiredmortgage adetached income fortax -

30%

20%

% of of median pre % 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada Toronto and area Montréal and area Vancouver Calgary

Source: Statistics Canada, RBC Economics, RBC Capital Markets Research

 We expect business lending growth to be higher than household credit growth, albeit growth should slow from the high rates of growth recently. Historical growth in business lending has been more volatile than in household lending and it was negative in this past recession, as was the case in the recessions of the early 1980s, 1990s, and

17 The Canadian government announced on June 21, 2012 four measures for new government-backed insured mortgages with loan-to-values above 80%. The rules took effect July 9, 2012. For changes made in the prior three rounds of government actions, please see sub-section “Mortgage insurance mainly provided by the Canadian government”. September 18, 2013 67 Canadian Bank Primer, Sixth Edition

2000s. Growth recovered as the business investment cycle (which is highly correlated to business loan growth) improved, and we expect loan growth to slow to the 5-10% range as the investment cycle continues to run its course.  Compared to the last business investment cycle, we believe Canadian banks have gained significant market share from banks with less strong balance sheets and we also believe that off-balance sheet conduits that would have been indirect providers of credit to business “pre-crisis” have become much smaller. Business loan balances for Canadian banks troughed in H1/10 and total bank balance growth has improved since then to double digit growth (Exhibit 52).  The other difference with prior cycles (which is negative) is that businesses might look to lock in low financing costs for an extended period and, as such, might be more willing to issue debt than take out shorter-term bank loans. This is an opportunity available for larger business but not for mid-market and smaller commercial clients. While at the margin a negative for growth in Canadian banks’ loan books, it is positive for their debt underwriting revenues. Exhibit 48: Mortgage and consumer lending likely to slow, partly because rising leverage is unlikely to fuel loan growth

Canadian Loan Growth (YoY) Household Debt (Since 1972) (Since 1990)

40% 23% 25-year Average Most Recent Loan Loan Growth: Growth: 22%

30% Consumer: 8.0% Consumer: 2.2% 21% Mortgages: 8.1% Mortgages: 4.9% Commercial: 3.6% Commercial: 12.1% 20% 20% 19%

10% 18% 17%

0% 16%

15% -10% 14%

13% -20% 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Consumer Res. Mortgages Commercial Canadian Household debt as % of Assets U.S. Household debt as % of Assets

As of June 30, 2013. Source: RBC Economics, RBC Capital Markets

Exhibit 49: Household debt-to-PDI has risen in Canada; Mortgage credit growth higher than PDI growth in past decade

Household debt to Personal disposable income Canada: Household Debt vs. Personal disposable income % (Based on credit market debt) (Since 1991) 180 % Chg YoY 14.0% On average, U.S. households spend 14% of their personal disposable income (PDI) on 160 healthcare vs. 4% in Canada due to 12.0% differences in each country's healthcare system. Deducting this "core" expense from 140 PDI, U.S. household debt to PDI is 10.0% approximately 6% higher than Canada.

8.0% 120

6.0% 100

4.0%

80 2.0%

60 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 0.0% 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada U.S. U.K. Australia Household Debt Personal Disposable Income As of March 31, 2013. Source: RBC Economics, RBC Capital Markets

September 18, 2013 68 Canadian Bank Primer, Sixth Edition

Exhibit 50: Canadian housing prices are high

Existing home sales price (YoY % chg) Price Index Existing Home Price Index (Since 1981) Jan-88 = 100 30% 600 25%

20% 500

15% 400 10%

5% 300 0%

-5% 200

-10% 100 -15%

-20% 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 0 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada U.S. Canada BC Alberta Ontario Québec

Data as of July 31, 2013. Source: RBC Economics, RBC Capital Markets

Exhibit 51: Business credit growth closely tied to business investment cycle; Leverage has improved over 20 years

Corporate Leverage Canadian Business Credit vs. Business Expenditure (Since 1990) (Since 1983) *Correlation Coefficient: 0.75 40% 300%

30% 270%

20% 240%

10%

210%

180% -10%

150% -20% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Business Credit YoY Growth Business Expenditure YoY Growth Canadian Corporate Debt-to-Equity Ratio U.S. Corporate Debt-to-Equity Ratio *Business credit growth lagged one year for correlation

Business Credit as of August 2013. Business Expenditure as of May 2013. Corporate debt-to-equity ratio as of March 31, 2013. Source: Company reports, StatsCan, RBC Economics, RBC Capital Markets

September 18, 2013 69 Canadian Bank Primer, Sixth Edition

Exhibit 52: Big Six banks have gained market share of business lending while other chartered banks have lost share

Chartered banks Big Six Bank Share Business loans C$ 2008 2010 Jun-13 2008 2010 Jun-13 BMO 6.9% 9.0% 8.7% BNS 5.1% 5.7% 5.7%

CM 3.3% 4.9% 5.2% 30% 40% 41% NA 2.7% 4.1% 4.1% RY 7.1% 10.0% 10.5% TD 4.5% 5.9% 7.0% CWB 1.4% 1.9% 2.2% LB 0.5% 0.8% 0.9% All other chartered banks 44.4% 31.7% 30.3% Non-bank Trusts and MortgageCos 0.7% 0.8% 0.9% Credit unions/Caisse populaires 12.1% 14.6% 15.0% Non-depository credit companies 11.2% 10.5% 9.5% 100.0% 100.0% 100.0%

Note: For Trusts, Mortgage companies, Credit unions, and Non-depositories. Market shares do not include life insurers and investment funds. Source: Bank of Canada, OSFI, Company reports, RBC Capital Markets Research

Margins on loans will depend on risk, with lower-risk products such as mortgages generating lower margins, and higher-risk products such as credit cards generating higher margins. Net interest income margins are also affected by funding sources; banks that source more of their deposits from retail customers normally have higher margins, and within the retail funding bucket, transaction accounts generate higher margins than savings accounts and guaranteed investment certificates (GICs).

Margins generally declined in retail businesses since the early 2000s, a trend that we expect will abate in the medium term as we discuss in the next section (Exhibit 53).

 For most of the last 15 years, retail loan growth has been more rapid than retail deposit growth, which has led to banks funding more of their retail assets with generally more expensive wholesale funds or through the securitization market. If disclosed, it would be fair to include small-business deposits as well as some commercial deposits as “core”, sticky, low-cost deposits, but it is unfortunate that most disclosures lump wholesale deposits with those. We estimate that retail deposits including small business and commercial deposits would range from 71% (CIBC) to 109% (TD Bank) of retail loans.  Alternatives to traditional savings accounts, such as high-yield savings accounts and money market funds, have grown in popularity in the last decade, with both trends negatively affecting margins.  Lower-margin secured lending, such as real-estate backed lending, has grown more rapidly than unsecured lending. The combination of residential mortgages and home equity lines of credit rose to 78% of consumer debt in 2012 from 74% in 2002 according to Investor Economics, and we believe this is likely close to 80% now (Exhibit 55).  The increased emphasis on economic capital and decreases in regulatory capital requirements for retail loans have encouraged pricing competition, in our view. We believe that with banks placing a greater emphasis on economic-capital models they became more willing to accept lower prices for low-risk assets since they began allocating less capital to support the income generated by those loans. The large Canadian banks have all increased their emphasis on economic capital models in the last 10 years.

September 18, 2013 70 Canadian Bank Primer, Sixth Edition

 Net interest income margins are typically dictated by industry discipline on asset and deposit pricing, which normally is inversely correlated to the improvement in the credit environment and by interest rates to a lesser extent. Banks will typically be more aggressive on product pricing when loan losses and/or funding costs are falling. In addition, a low rate environment pressures bank margins in retail banking as well as retail brokerage, and low reinvestment yields on five-year assets hurt margins on zero- cost deposits (as discussed in more detail below) (Exhibit 54).

Exhibit 53: Retail net interest income margins have declined over time

Net Interest Margin - Retail and Total Bank (Quarterly Since Q1 2001) 4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0% 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13

Retail Net Interest Income/Retail Earnings Assets Total Bank Net Interest Income/Earnings Assets

Average Big Six Banks. Source: Company reports, RBC Capital Markets

Exhibit 54: Net interest margins normally narrow when loan losses decline and the yield curve is flat

Net Interest Margin vs. Yield Curve (5yr - 3mo) Net Interest Margin vs. Loan Loss Provisions as % of Total Loans (Annual Since 1998) (Quarterly Since 2000) Correlation Coefficient: 0.56 1.40% 2.6% Correlation Coefficient since 2000 : 0.55 3.1% 2.4%

1.20% 2.4% 2.5% 2.2% 1.00% 2.2% 1.9% 2.0% 0.80% 2.0% 0.60% 1.3% 1.8% 1.8% 0.40% 0.7% 1.6% 1.6% 0.20% 0.1% 1.4% 0.00% 1.4% -0.5% 1.2% -0.20% 1.2% 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 2Q00 1Q01 4Q01 3Q02 2Q03 1Q04 4Q04 3Q05 2Q06 1Q07 4Q07 3Q08 2Q09 1Q10 4Q10 3Q11 2Q12 1Q13

Yield Curve: 5yr - 3mo (LHS) NIM (NII/Average Earning Assets) (RHS) NIM (NII/Average Total Assets) (RHS) Total Provisions (LHS) Net Interest Margin (RHS)

Correlation between 5-year Canadian Govt Bond and 3-month Canadian Govt T-Bill spreads and Net interest margins (average earning assets). Annual yield curve is the average of the daily yield curve. Net interest margins and specific provisions for credit losses are the average of Big Six banks. Source: Company reports, Bank of Canada, RBC Capital Markets

September 18, 2013 71 Canadian Bank Primer, Sixth Edition

Exhibit 55: Secured lending has grown since 2002; Majority of household debt is real estate backed

Household Debt Household Debt 2002 2012

Personal lines of Personal lines of credit, 4% Credit cards, 7% credit, 6% Credit cards, 6% Installment Home equity lines Installment Home equity lines loans, 13% of credit (HELOCs), loans, 11% of credit (HELOCs), 5% 11%

Mortgages, 69% Mortgages, 67%

Source: Source: Investor Economics, RBC Capital Markets

Exhibit 56: Fewer retail loans are funded with personal deposits compared to the early 1990s

Personal Deposits as % of Total Loans Personal Deposits as % of Retail Loans (Annual since 1986) (Annual since 1986) 65% 25% 25%

150%

60% 21% 20% 130%

55% 17% 15% 110%

50% 13% 10% 90%

45% 9% 70% 5%

40% 5% 50% 0% 86 88 90 92 94 96 98 00 02 04 06 08 10 12 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Personal Deposits % Total Loans (LHS) Securitized Assets as % Loans (RHS) Personal Deposits % Retail Loans (LHS) Securitized Assets as % Retail loans (RHS)

Total Big Six Banks, includes international deposits and international retail loans. Source: Company reports, RBC Capital Markets

We forecast margin pressure to abate in 2014 based on current interest rates, and margin improvement in 2015 is likely if there are further increases in short- and medium-term rates. The recent increase in 5-year bond yields should reduce the margin pressure banks are facing in 2014 and if 5-year yields rise further, it could lead to margin expansion on zero-cost funds in 2015. Furthermore, higher short term rates, when they occur, should help margins on certain types of deposits such as high yield savings accounts and short-term GICs, while loan mix should improve (greater growth in commercial mortgages than residential mortgages) and growth in loans and deposits should be more balanced as loan growth slows.

 We expect loan pricing to be stable. We believe that, in an environment where credit costs are declining and revenue growth is “easier”, banks price more aggressively, as happened in the past including 2011. At the margin, we expect less incremental price competition as we do not expect lower credit losses to be a positive earnings driver in 2014/2015. Also, with wholesale funding costs no longer in a declining trend as they

September 18, 2013 72 Canadian Bank Primer, Sixth Edition

were from 2009 to early 2010, we believe the banks are incentivized to behave more conservatively on loan pricing.  Deposit pricing, relative to risk-free rates, is likely to be higher than “normal” as banks are incentivized to gather more retail funds under new regulatory liquidity rules, and also incentivized to extend the term of their wholesale funding. We do not expect the pressure to increase as we believe that the banks are well positioned to meet the Basel liquidity requirements, which are to be introduced in 2015, and were eased earlier this year versus prior proposals. In January 2013, The Basel Committee updated its Liquidity Coverage Ratio guidance, which we viewed (and still view) as positive relative to the prior guidance as (1) the definition on liquid assets is more lenient, (2) deposit outflow assumptions are less punitive, and (3) the implementation will be phased in from 2015 to 2019 rather than fully implemented in 2015.  We believe that the recent increase in the 5-year interest rates will lead to margin pressure abating in 2014 and any further increase is likely to lead to margins improving from current levels. Banks normally do not match zero cost funds with short-term assets but instead lend or invest at longer durations (about five years on incremental assets). The margins they earn on zero-cost funds therefore rise (or fall) if new asset yields are higher (or lower) than the average of the prior five years. This dynamic had been negative for bank margins for a multi-year period but the recent increase in 5-year yields has pushed new asset yields close to the average of the last five years.(Exhibit 57)  Changes in loan mix as well as in loan growth should be positive for margins. We expect slower mortgage loan growth in upcoming years, and greater growth in commercial loans, which should be positive for margins. Also, the shifting consumer preference for fixed rate mortgages over variable rate mortgages should also be positive for margins. Lastly, we expect growth in retail loans and deposits to be more balanced than in the past as loan growth slows toward personal disposable income growth, which also should be positive for margins.  Also potentially positive, higher short-term interest rates, when they occur, would have positive implications for deposit margins. The low interest rate environment has been a source of pressure on bank margins in retail banking as well as retail brokerage. (1) Margins on high-yield savings accounts and short-term GICs are likely to increase when short-term interest rates increase as we expect banks will not pass on the full benefit of rate increases to customers, which would be the reverse of what happened as short-term rates declined to close to zero – banks have kept paying a nominal rate of interest to attract short-term deposits. As an aside, margins on money market funds should improve as banks still waive fees for most money market products and should eventually stop the waivers in a higher short-term rate environment.

September 18, 2013 73 Canadian Bank Primer, Sixth Edition

Exhibit 57: Impact of low medium-term interest rates on margin to stabilize

Canadian 5-year bond yields / 5-year moving average (Q1/05 - Q4/14E) (%) 5.25

Canadian 5-yr 4.50 bond yields held steady at 1.95% 3.75

3.00

2.25

1.50

0.75

- Q1/05 Q1/06 Q1/07 Q1/08 Q1/09 Q1/10 Q1/11 Q1/12 Q1/13 Q1/14E Quarterly average 5-year Canadian bond yield 5-year moving average yield

Source: Company reports, Bloomberg, RBC Capital Markets estimates

Exhibit 58: Wholesale funding costs are down from peak levels, while retail funding costs have come down recently

Bank 5-Year Sr Debt and Canadian Corporate Debt Spreads 5-Year GIC (over the 5-year Government of Canada bond) (over the 5-year Government of Canada bond)

350 1.5

300 1.0 250 0.5 200 -

150 Spread (bps)

Spread(bps) 100 (0.5)

50 (1.0) - Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 (1.5) Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Bank 5-Year Sr Debt Canadian Corporate AA 5yr 5 Year GIC over GoC bond

Source: Company reports, RBC Capital Markets

Banks also include small business and mid-market commercial operations as part of their retail divisions. For banks that have disclosed details, business loans make up about 15–20% of their retail loans.

 Small business and commercial clients often have more in deposits than assets, which provides a counter balance to individuals who generally have more in loans (including mortgages) than deposits.  We view small-business banking as an extension of personal banking, with similar products and services offered, as well as additional items, which reflect the needs of small businesses. Those items include electronic payment solutions (credit cards and debit), payroll services, foreign currency services (wires, drafts, and letters of credit), and group savings plans. Not all banks have the same cut-off, but business clients with borrowing needs of up to about $500,000 could generally be categorized as small- business clients.

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 Services offered to commercial clients would be similar to those offered to corporate clients, although businesses such as equity and debt underwriting would not be relevant to this customer segment. Banks provide term loans, asset-backed lending, and mortgage lending, as well as operating lines, cash-management support, foreign- exchange services, payroll solutions, and group savings plans.

Non-interest income contributes 25-30% of retail revenues Banks also generate non-interest income from sources such as account fees, transaction fees, credit card fees, insurance revenues, foreign exchange revenues, and credit-related fees. Non-interest income represents 25–30% of revenues for retail divisions.

 Account fees include fees charged on chequing and savings accounts, for example, which can be $10–20 per month for accounts with unlimited transactions (or up to $30 per month for premium accounts, or less than $5 per month for limited transactions). Account fees are also charged on premium credit cards ($120 per year for CIBC’s Aerogold or Aventura card, Royal Bank’s Avion card, and TD First Class Travel Infinite card).  Transaction fees can include ATM fees charged to customers who use competitors’ ATMs or to non-customers that use the bank’s ATMs, fees on cheques, money transfers, bill payments, and direct payments for accounts with limited monthly transactions, as well as fees charged on bank drafts, or service fees for overdrafts, and other items. Note: Unlike in the US, Canadian banks do not generate interchange fees off debit card transactions (they only do so off credit card transactions).  Credit card fees are paid by merchants every time a customer makes a transaction, based on percentage of the value of transactions (usually ranging from 1.50% to 2.25%) and on monthly fees for premium cards.  Insurance revenues are derived from providing creditor insurance to mortgage and credit card customers; property and casualty insurance premiums for TD, and RBC to a lesser extent; and life, disability, and travel insurance for RBC and Bank of Montreal. Insurance revenues are not always comparable—TD and Bank of Montreal show revenues net of claims costs, while RBC splits out revenues and claims costs.  Foreign exchange revenues arise when customers exchange currency in branches, selected ATMs, or use credit cards and debit cards outside Canada.

Operating expenses are mostly composed of compensation costs, but infrastructure costs, such as premises, information technology, and communications, are also high. Operating expenses include insurance claims and benefit expenses in the case of banks that do not net them against revenues.

 Retail expenses typically account for about 50% of retail revenues (total bank expenses account for 55–60% of total bank revenues), and they have generally been declining for the industry since 2001 (Exhibit 59).  We would focus on expense-ratio trends by bank rather than comparing absolute numbers between banks, because banks do not allocate revenues and costs in the same way between divisions, including the “corporate and other” division. Some banks may retain more costs centrally, which may help the operating profitability of the division compared to that of a bank that allocates centralized costs to divisions more aggressively.

Loan losses fluctuate with the economy, with the most important driver of retail loan losses being employment growth, as detailed in “Section 7: Loan losses can be material, but exposure has declined”. Retail loan loss provisions have improved since late 2009, but we September 18, 2013 75 Canadian Bank Primer, Sixth Edition

expect provisioning rates to be stable in 2014 and 2015 as employment growth and the change in the unemployment rate (the most relevant predictors of personal loan losses, in our view) are pointing to a stable credit environment in personal lending. Canada witnessed rapid job creation coming out of the recession and recently the economy has created 72,000 net jobs in the past six months, versus just 163,000 in the prior six months and 190,000 in 2011. The unemployment rate is currently 7.1%, which compares to a peak of 8.7% in August 2009.

Exhibit 59: Retail productivity ratio has improved in the last six years

Productivity Ratio (Quarterly Since 2000) 75%

70%

65%

60%

55%

50%

45%

40%

35% 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13

Median Big 6 Median Big 6 - Retail Median Big 6 - Wholesale

Canadian retail non-interest expense/revenue. Median Big Six Banks. Source: Company reports, RBC Capital Markets

Mortgages and credit cards are key retail lending products Mortgage loans represent about two-thirds of household debt while home equity lines of credit represent approximately another 11%. Credit cards represent a small proportion of household debt (~6%), but the yields are higher than for other types of loans, and the provisions for credit losses are higher, so credit card businesses have a larger effect on retail divisions’ income statements than the loan balances would indicate. Disclosure on loans other than mortgages and cards is not as granular among all banks. Those loans include lines of credit (secured and unsecured), auto loans, term loans, and commercial loans. The Big Six Banks are the leading retail lenders in Canada, with about 75% market share in residential mortgages and credit cards.

Mortgages account for the largest share of retail loans The largest retail lending product for banks is mortgages (comprising 60–65% of loans to individuals). Mortgages are a low-margin product, reflecting their low-risk profile, as well as the banks’ view that mortgages are an anchor product (i.e., many banks believe that mortgages can “buy” them customers to whom they can subsequently cross-sell other products, although we believe that transaction accounts are better anchor products than mortgages). Mortgages are low-risk loans for the banks because they only compete in the prime mortgage segment of the market (no sub-prime), and structural features of the Canadian mortgage market make mortgages low risk (for further discussion, see “Section 11: Key differences with US banks”). Banks have been most successful at cross-selling creditor insurance for mortgages (which covers the mortgage balance in the event of death or

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disability), likely a high-margin product for banks given limited competition at the point of sale.

Banks make money on the spread between the mortgage rate and the cost of the funds used to fund the mortgage, which come from retail or wholesale deposits, unless the mortgage is securitized or sold. Estimating spreads on mortgages is an exercise that works well in “normal times” but is more difficult in environments where wholesale funding spreads are high or when discounts against posted rates vary.

 Normally, for fixed-rate mortgages (which account for 60–70% of mortgages), we believe that spreads on incremental mortgages can be estimated as follows: five-year market mortgage rates less five-year senior debt rates (as an estimate of marginal wholesale funding costs). Over the past 20 years, the spread between posted mortgage rates and market rates has become greater as funding costs have declined. Currently, the market mortgages rate is ~ 200 basis points under the posted mortgage rate versus ~120 basis points 10 years ago and ~60 basis points 20 years ago (Exhibit 60).  For variable-rate mortgages, pricing is normally set at a discount to the prime rate, which we estimate averages 75 basis points in normal times but can move to more than prime when banks’ wholesale cost of funds are high, as was the case in late 2007 and early 2008, or when banks are trying to influence mix, such as is currently the case with lower than normal discounts (we believe discounts are now approximately 40 basis points below the prime rate, with pricing getting closer to normal after being closer to the prime rate plus or minus 10 basis points during the past year) as banks are pushing customers into fixed-rate options. The disclosure on discounts relative to the prime rate is generally not available. Bank margins on incremental variable mortgages, therefore, would be the prime rate adjusted for discounts minus the cost of term funding swapped to a short-term floating rate (banks attempt to fund on a duration that matches the duration of a mortgage and an interest payment that reduces interest rate risk).  Normally, the cost of wholesale funds can be approximated by using short-term BA rates. Assuming that the cost of converting fixed-term interest rates to short-term rates is about 15 basis points, this would lead to margins on variable rate mortgages of about 90 basis points based on a normal Prime/BA spread of 180 basis points (Exhibit 61). The increases in term funding rates for banks, however, has made using short-term BA rates a less accurate estimate of the cost of banks’ funding for variable rate mortgages. To use one example, indicative costs for a five-year senior debt issue (on a swapped to float basis) from a Canadian chartered bank increased from BA + 15 basis points in July 2007 to its current estimated level of BA + 90 basis points. All else being equal, and even without any changes in the Prime/BA spread, the higher senior debt cost since early 2007 would translate into a margin compression for mortgages funded by bank debt of 75 basis points. Offsetting that negative effect of higher-term funding costs compared to pre-2007, the Prime/BA spread is currently 15 basis points wider than the historical spread.  Note: The above discussion of margins is meant to estimate pricing on a mortgage incrementally funded in unsecured wholesale markets. Since customer deposits, the securitization market and covered bonds are also used to fund mortgages, the average spread on the entire book would be higher than on incremental mortgages funded in the unsecured wholesale market. The securitization and covered bond markets are inexpensive sources of funds as well relative to unsecured wholesale funding.

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Exhibit 60: The discount to posted rate had increased over the last 20 years

Mortgage Rates: Posted and Market (Since 1990) 15% 10.0%

14% 9.0% 13%

12% 8.0%

11% 7.0% 10% 6.0% 9%

8% 5.0%

7% 4.0% 6%

5% 3.0%

4% 2.0% 3% 1.0% 2%

1% 0.0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Spread: posted vs. market (RHS) Posted Mortgage Rate Market Mortgage Rate

Source: Bank of Canada, ING Direct, RBC Capital Markets

Exhibit 61: Spread for fixed-rate mortgage rates (over bank senior debt) and Prime/BA spread higher than normal

5 yr Market Mortgage Rates vs. 5 year Senior Debt Prime-BA Spread (Monthly Since 1999) 2.8 10% 4.0% 2.6 3.0% 2.4 8% 2.2 2.0% 2.0 6%

1.0% 1.8 Spread(bps) 1.6 4% 0.0% 1.4 1.2 2% -1.0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 1.0 Market Mortgage Rate (LHS) 5 year Canadian Bank Senior Debt (LHS) Spread (RHS) Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Market mortgage rate: median mortgage rate by Canadian chartered banks. Source: Bank of Canada, RBC Capital Markets

Mortgage loss rates for the Canadian banks are extremely low. They were 5 basis points for 2012 (which would be much lower if excluding the Canadian banks’ US and International operations) while the 20-year average is 3 basis points (please see “Section 7: Loan losses can be material, but exposure has declined” for more details as to why Canadian mortgage loss rates are so low). We expect loss rates for mortgages to remain well below other types of loans.

Capital requirements are very low for mortgages, reflecting their benign historical loss experience. The risk weighting for uninsured residential mortgages would be between 10- 15% for the Big Five Canadian Banks, given that they operate under the advanced method. Insured residential mortgages (65% of the banks’ mortgage books) have 0% risk weightings.

 The low capital requirements allow banks to generate very high marginal ROE on mortgages despite the low spreads. If one assumes a spread of 75 basis points on a mortgage that is risk weighted at 10% and a 9% common equity-to-risk-weighted assets

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ratio, the ROE would be about 58%. This analysis ignores operating expenses since it is a marginal return analysis and excludes capital allocated for operational risk, so ROE on a fully weighted cost analysis would be lower (Exhibit 62).

Exhibit 62: Example of marginal return on mortgage (ex. expenses/operational risk capital)

Mortgage $ 100,000

Interest rate charged 3.75% Prime rate 3.00% Spread earned 0.75% Pre-tax return $750 Post-tax return (assume 30% tax rate) $525

Risk-weighted assets (assume 10%) $10,000 Common equity (assume 9%) $900

ROE 58%

Does not include operating expenses or operational risk capital. ROE would be lower. Source: RBC Capital Markets estimates

Residential mortgage credit outstanding grew at a 10% compounded growth rate since 1970 (7% since 1990), peaking at 23% in 1974 and troughed at -1% in 1982. Mortgage growth tends to be stronger when employment and GDP growth are positive, and when housing markets are stronger (i.e., when price appreciation is greater, starts are rising, and sales activity is higher). The most recent year-over-year growth rate in residential mortgages was 4.9% in the 12 months ended June 2013, down from 8.0% in October 2011 and 13.0% in May 2008.

 Growth in mortgage lending balances is influenced by bank market share of the mortgage-origination market (which has declined as mortgage brokers have gained market share in the last decade, which benefited non-bank mortgage originators) as well as the health of the housing market, with the main indicators to watch for being trends in home price appreciation, housing starts, home sales, mortgage affordability and employment growth. Mortgage brokers have an approximately 30% market share of mortgage originations in Canada, a trend that had been steadily increasing over the past decade but has shown signs of stabilizing in the last few years; this compares to a 45% market share for bank branches (a steadily decreasing trend) and 25% market share for bank mobile-sales forces (a steadily increasing trend). The Big Six banks’ market share of the mortgage market overall is about 70-75%.

We expect growth in Canadian mortgage lending to decline from the current ~5% level to the 2–3% range as rising leverage is unlikely to fuel loan growth, as it had in the past. We believe that the changes that were made by OSFI around HELOCs (particularly limiting HELOC LTVs to 65% and stricter guidelines for self-employed borrowers) and by the Canadian Government on the type of mortgages they insure have helped reduce the rate of household credit growth, and that further changes in loan underwriting could be put in place by CMHC in an effort to reduce the pace of household credit growth, unless loan growth (currently ~5%) slows to a pace similar to disposable income growth (currently ~3%). Personal disposable income growth is expected to be in the 2–3% range in the next few years, which we believe should be the main driver of loan growth.

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 Mortgage affordability remains at the high end of normal ranges, but it could move above normal ranges if employment gains ebbed and/or interest rates rose. Deteriorating affordability would lead to slower loan growth, in our view (Exhibit 47).

Mortgage insurance mainly provided by the Canadian government Before we move on to other types of loan categories, we believe it is worth discussing the nature of the Canadian mortgage insurance market because so much of the Canadian banks’ mortgages are insured (and therefore have no credit risk for banks despite being on their balance sheets).

Mortgage insurance is either bought by customers in situations where they cannot make a down payment that is at least 20%18, or by banks, who may purchase insurance on a pool of uninsured mortgages (where borrowers made a down payment of at least 20%) for reasons including mitigating credit risk; access to low-cost mortgage funding via CMHC’s conduits (which require that all CMHC-securitized mortgages be insured); and to a lesser extent, better regulatory capital treatment (i.e., lower risk-weighting). Until recently, some banks also purchased bulk insurance on mortgages used for collateral in covered bond programs to reduce the risk (and spread) for investors; however, the Canadian government passed legislation that banned the use of insured mortgages in covered bond programs.

 We believe that between 40% and 50% of industry net insurance-in-force is for low-LTV mortgages (i.e., purchased by banks or other institutions) despite the attractiveness of mortgage insurance for capital reasons having declined for banks.19 The rest of in-force insurance would be for high-LTV mortgages, representing insurance bought by borrowers who did not make a 20% down payment at the time of origination. CMHC has announced that it will pull back from providing bulk insurance on low LTV mortgages, so the mix of insured mortgages is likely to shift toward high LTV mortgages unless lenders shift bulk insurance needs to private mortgage insurers.  The Canadian mortgage insurance market is concentrated, with CMHC, a crown corporation, controlling about 80% of the market (based on insurance-in-force) and Genworth MI Canada the majority of the remainder. A newer player, Canada Guaranty (formerly AIG’s Canadian mortgage insurance business, which was acquired in 2010 by the Ontario Teachers’ Pension Plan and a co-founder of First National Financial, the largest non-bank mortgage originator in Canada) also competes in the market and we believe has <5% market share.  CMHC is backed by the Government of Canada. In contrast to the 100% backing of CMHC by the Government of Canada, private mortgage insurers have a 90% backstop from the Government of Canada (i.e, if they were to become bankrupt or insolvent, the government would guarantee 90% of the original principal amount of insured loans).  The Canadian government has two limits for net insurance-in-force that mortgage insurers can underwrite in total: (1) $600 billion for CMHC, which was increased from $450 billion in 2008; and (2) $300 billion in aggregate for all other private mortgage insurers. CMHC’s insurance-in-force has reached $563 billion as at March 31, 2013, and the private insurers’ insurance-in-force we estimate is approximately $160 billion. It is important to understand that the limits are based on net (not gross) insurance-in-force (i.e., gross insurance-in-force minus amortization/pre-payments).

18 Borrowers must make a down payment of at a minimum 5%. 19 Under Basel I, insured mortgages had a risk weighting of 0% compared to 50% for uninsured mortgages, whereas under Basel II, which Canadian banks have operated under since the beginning of 2008, uninsured mortgages for the Big Six banks have a risk weighting of less than 10%. Mortgages insured by CMHC have zero risk weightings (same as before). September 18, 2013 80 Canadian Bank Primer, Sixth Edition

In the event that a customer cannot meet down payment targets and must get mortgage insurance:

 The bank pays an upfront premium to the mortgage insurer (the premium will vary on factors such as the type of borrower, LTV, credit record, and debt servicing capability), and then the bank grosses up the principal amount of the mortgage, so the borrower ends up paying for the premium.  The mortgage will be insured even if the consumer pays down the principal to levels that drive a LTV lower than 80% given that the premium was essentially paid up front (i.e., the mortgage remains insured over the life of the mortgage).  The mortgage will remain insured even if the rate on the mortgage is changed.  The mortgage will remain insured even if the mortgage is transferred to another lender (as long as the loan size does not go up).

If a customer with an insured mortgage becomes delinquent, banks first try to work with those customers to restore their status as current (whether it is giving the customer time to find a new job, restructuring the mortgage by deferring payments, extending the duration, or other options). We believe that the overwhelming majority of situations (greater than 80%) are resolved that way. In recent years, banks and mortgage insurers have sought to help prevent delinquencies by addressing potential issues earlier in the process (e.g., when the first payment is missed or if a borrower contacts the bank or mortgage insurer before missing a payment). In addition, banks are often bringing in the mortgage insurer into the process of curing a potential delinquent borrower a lot earlier than the contractual 90 days delinquent requirement.

If a mortgage remains delinquent for a longer period of time (i.e., more than 90 days), we believe that the banks become more worried about collectability and will initiate the process that could ultimately result in foreclosure (a process that can take six to 18 months, depending on the jurisdiction).

 The mortgage insurers would normally work with the banks along the way, but it is normally the bank that will have primary contact with the borrower.  The cost associated with trying to cure a borrower who has missed a payment is borne by the insurer, not the bank. As such, the mortgage insurers will reimburse banks for any loss on the mortgages once the process is terminated (i.e., the house has been foreclosed and sold) and any out-of-pocket costs such as legal and real estate fees. Banks’ costs would be limited to the operating costs of having a restructuring or work out group.  Mortgage insurers can put back mortgages to banks if a loss occurs because of a fraud.

CMHC has made four rounds of changes to make the underwriting of mortgages more conservative in the last five years, in an effort to support the long-term stability of Canada’s housing market.

 In August 2008, the Government of Canada announced restrictions on the types of insured mortgages that it would guarantee, which effectively eliminated some of the higher-premium mortgage insurance products offered to consumers. These restrictions included: 1) cutting the maximum amortization period to 35 years from 40 years; 2) minimum 5% down payment; 3) minimum credit score of 620; 4) new loan documentation standards; 5) maximum 45% total debt service ratio; and 6) excluding high-LTV mortgages where there is no amortization in the first few years.  In April 2010, the Government of Canada changed mortgage insurance government guarantee rules as follows: 1) it required all borrowers meet the standards for a five-year September 18, 2013 81 Canadian Bank Primer, Sixth Edition

fixed-rate mortgage even if they choose a mortgage with a lower interest rate and shorter term; 2) it lowered the maximum amount borrowers can withdraw in refinancing their mortgages to 90% from 95% LTV; and 3) it required a minimum down payment of 20% for government-backed mortgage insurance on non-owner-occupied properties purchased for speculation.  In March 2011, the Government of Canada made three changes: 1) it reduced the maximum amortization period to 30 years from 35 years for new government-backed insured mortgages with LTV ratios of more than 80%; 2) it lowered the maximum amount that Canadians can borrow in refinancing their mortgages to 85% from 90% of the value of their homes; and 3) it withdrew government insurance backing on lines of credit secured by homes (HELOCs).  On July 9, 2012, the Government of Canada made four more changes for new government-backed insured mortgages with loan to values of more than 80%, which were to: 1) reduce the maximum amortization period to 25 years from 30 years; 2) lower the maximum amount that Canadians can borrow in refinancing their mortgages to 80% from 85% of the value of their homes; 3) fix the maximum gross debt service ratio at 39% and total debt service ratio at 44%; and 4) limit the availability of government- backed insured mortgages to homes with a purchase price of less than $1 million.

OSFI has increased its oversight of real estate secured lending OSFI released final guidelines for residential mortgage underwriting practices and procedures in June 2012. The guidelines apply only to mortgage originators or purchasers, and not to mortgage insurers; OSFI indicated that it will release a separate set of guidelines applicable to mortgage insurers at a later date.

The majority of the changes served to incrementally tighten lending for stated income borrowers and HELOCs, in our view. The guidelines also increased compliance costs for lenders with respect to internal controls, loan documentation, and underwriting processes. The guidelines outlined key principles for sound residential mortgage underwriting, with a focus on: (1) governance, risk strategy, and Board oversight; (2) the borrower’s willingness and capacity to service debt, as well as the underlying collateral value; and (3) effective credit and counterparty risk management.

The majority of the guidelines largely formalized existing practices within the industry. Some of the highlights include:

 Stricter underwriting of non-conforming mortgages. For uninsured mortgages originated by federally regulated financial institutions (those originated with an LTV of 80% or less), general industry practice was (and still is) to have a maximum LTV of 65% for non-conforming mortgages20. OSFI expects the average LTV of a lender’s conforming and non-conforming loan book to be less than the lender’s stated maximum with reasonable distribution of loans by LTV.  Increased scrutiny throughout the term of the mortgage and on renewal or refinancing. OSFI expects banks (and other federally regulated financial institutions) to refresh borrowers’ credit metrics on renewal and on an ad hoc basis if conditions warrant, although it appears that a borrower’s good payment history may be considered sufficient to satisfy this guideline on refinancing or renewal. OSFI also expects that LTV ratios be monitored throughout the mortgage and recalculated on renewal and refinancing.

20 Definitions of non-conforming mortgages vary but generally include non-income qualifying loans, loans with low credit scores, high debt service ratios, illiquid properties, etc. September 18, 2013 82 Canadian Bank Primer, Sixth Edition

 The maximum LTV on HELOCs were reduced to 65% from 80% in cases where a borrower only has a HELOC (but no mortgage), whereas the maximum LTV remained at 80% for borrowers with a mortgage and HELOC, although the portion of the loan >65% LTV is required to be amortized.  Increased disclosure around the mortgage portfolio was required with a focus on Federally Regulated Financial Institutions’ (FRFI) domestic residential mortgage operations, including key metrics such as: average loan-to-value, total debt servicing and gross debt servicing ratios, and HELOCs.  For higher-risk, illiquid, or unique properties, a comprehensive on-site appraisal (or another other appropriate approaches) is now required for new originations as well as renewals or refinancings. Automated valuation processes are still valid for more liquid properties, but federally regulated financial institutions must ensure that appropriate controls are in place and their effectiveness must be evaluated on an ongoing basis.  Federally regulated financial institutions are expected to perform stress testing on their mortgage portfolio in order to appropriately monitor and review the risk parameters used in developing their underwriting models. A link to the OSFI regulations can be found at http://www.osfi-bsif.gc.ca/osfi/index_e.aspx?ArticleID=4831.

Credit cards – higher margin and higher risk The Canadian banks are the leading issuers of credit cards, with the Big Six having a market share of about 75%. Credit cards represent a small proportion of household debt (~6%), but the yields are higher than for other types of loans, and the provisions for credit losses are higher, so credit card businesses have a larger effect on retail divisions’ income statements than the loan balances would indicate.

 Until November 2008, banks, by regulation, had to issue either Visa or MasterCard; National Bank and Bank of Montreal were (and still are) MasterCard issuers while the other four banks were Visa issuers. While the regulation was changed in November 2008 to allow for banks to issue more than one kind of credit card, it was not until recent years that banks began offering both brands (e.g., Royal Bank launched a MasterCard with WestJet, while CIBC purchased a portfolio of MasterCard receivables and TD Bank bought MBNA Canada’s MasterCard portfolio).  The banks face more foreign competition in credit cards than they do in other retail banking products. Amex and Capital One are present in Canada, and larger retailers such as HBC and Canadian Tire also offer credit cards.  Credit cards account for only 4% of total loans, but their contribution to the banks’ income statement is greater than implied by their loan weight because margins and loan losses on credit cards are much higher than on other lending products. For example, credit card provisions made up about 35% of total consumer-related provisions for credit losses in recent years for the banks that separately disclose card provisions.

Banks make money on credit cards from the spread between the banks’ funds rate and the card interest rate, transaction fees charged to retailers, and annual cardholder fees.

 Banks charge a high interest rate on credit cards (typically high-teens on purchases and low-20% for cash advances, although lower rate cards are available with conditions), and capture the spread between their funding costs and the credit card interest earned—we estimate approximately 12–15%. This high rate reflects the fact that losses are higher than with other loan types and that balances are unsecured.  The Canadian marketplace has proved fairly price insensitive in the past, with interest rates not moving down in concert with declines in other interest rates.

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 Reflective of the high interest rates, rollover rates (we define rollover as card balances and debt carried from one month to the next) are much lower in Canada than in the US (i.e., fewer people use their card as a borrowing vehicle). We believe that rollover rates in Canada are approximately 40% compared to 60% in the US.  Annual cardholder fees range from $0 to $120 depending on the benefits offered, such as travel points and car insurance.  Banks generate about 1.5% in transaction fees from each transaction. The importance of transaction fees is higher in Canada than in the US because of the lower balance-rollover rate. Transaction fees are a high ROE and low credit-risk source of revenues.  Banks often aim to sell creditor insurance for credit card balances, likely a high-margin product for banks given limited competition at the point of sale.

Credit card rules changed in Canada as of September 1, 2010, which had a small negative effect on the profitability of banks’ credit card businesses but not large enough to be separately disclosed. The rules targeted: 1) the allocation of payments on balances having different interest rates (which could now be more beneficial for customers than before); 2) a minimum 21-day grace period on making payments after the end of the billing cycle; and 3) a 21-day interest-free period for customers who pay their balance in full regardless of whether a balance was carried in the prior month (which is in contrast to the prior general practice of charging interest on new purchases from the date of purchase if a balance was carried in the prior month even if the current month balance was paid in full). We believe that the third point was the most meaningful one for Canadian banks.

ROE on incremental balances are very high.

 Basel II regulatory-risk weightings for credit cards (and other types of unsecured retail loans) are 75% for the regional banks operating under the Standardized method, and lower for the Big Six banks, which use the advanced method for most portfolios.  Banks generate very high marginal ROE on credit card balances. If one assumes a spread of 12%, losses of 4%, a risk weighting of 100% (including 50% for drawn balances and an additional 50% for estimated undrawn commitments), and an 9% common equity-to- risk-weighted-assets ratio, then the ROE would be 62%.(Exhibit 63) This analysis ignores fees and operating expenses since it is a marginal-return analysis, so ROE on a fully weighted cost analysis would be lower. This analysis is also simplistic and based on rules of thumb—recent spreads are likely higher given low short-term interest rates.

Exhibit 63: Example of marginal return on credit cards

Credit card balance $10,000

Interest rate charged 16.00% Cost of funds 4.00% Credit losses 4.00% Spread earned 8.00% Pre-tax return $800 Post-tax return (assume 30% tax rate) $560

Risk-weighted assets (assume 50%) $5,000 Additional RWA for undrawn commitments $5,000 Common equity (assume 9%) $900

ROE 62%

Does not include interchange revenues, operating expenses or operational risk capital. ROE would be lower. Source: RBC Capital Markets estimates

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Loan losses are the greatest cost for credit cards, but reward costs and operating costs (call centres, underwriting, and marketing) cannot be ignored.

 Credit card losses are significantly higher than other types of loans. For the Canadian banks, they have ranged from 3% to 6% of loans in recent years.  Banks offer many benefits to card holders, such as cash back, travel rewards, and points that are redeemable for merchandise, but the expenses related to those benefits programs are not separately disclosed. We believe that, in general, the premium interchange fee charged for premium rewards cards (~25-75 basis points higher than basic interchange fees) above the basic card interchange fee largely offsets the reward costs and that the profitability (excluding operating expenses) is driven by the basic interchange fee and net interest income net of loan losses.  Competition is generally fought on the reward side rather than on the interest-rate side, reflecting Canadians’ tendency to use credit cards as transaction tools rather than a source of borrowing. Competition for benefits has typically been intense.

Interchange fees could be impacted by changes in payment mix The Canadian Competition Bureau had challenged some aspects of Visa and MasterCard’s practices, requiring merchants to “accept all cards” and not allowing surcharging. The Bureau’s challenge was first announced in 2009, and on July 19th 2013, the Competition Tribunal dismissed the case on the basis that the “proper solution to the concerns raised is a regulatory framework”. Although the dismissal eliminated some near term risk, there remains some longer-term uncertainty on payment mix depending on a potential future regulatory framework. We stress that it is too early to come to any conclusion, but in the event that a new regulatory framework caused credit card usage to decline as a proportion of total payments, we believe that banks’ revenues would be negatively impacted.

A payments shift by consumers from credit cards to debit and cash, if it occurred, would have negative implications for banks’ revenues as Canadian banks generate direct revenues from credit card transactions, but not from debit card transactions (in Canada) or cash transactions. Banks also generate net interest income on credit card balances, and would also likely see a decline in balances if credit card usage became less popular.

Banks generate interchange fees on credit card transactions as issuers. At its core, interchange fees are justified by the banks’ role as intermediaries (they pay the merchant rather than, in a debit transaction acting as a conduit to an individual’s own funds), which allows merchants, at a cost of approximately 1.5% per transaction, to receive “cash” quasi- instantaneously. Banks take on the risk of fraud and non-payment, which is also why they charge customers interest on outstanding balances. Interchange fees are also used to offset the costs of offering loyalty programs. For credit cards with loyalty benefits such as travel rewards, interchange fees are higher than 1.5% (approximately 25-75 basis points higher).

We believe that interchange fees are a highly profitable source of revenues for Canadian banks. We believe that most of the profitability is derived from the “basic” interchange fees, with most of the additional interchange fees charged for premium cards being offset by the cost of running the loyalty programs. Card fee revenues account for ~4% of revenues for banks, as we summarize in Exhibit 64. We would caution that the disclosures are not perfectly comparable as (1) most but not all banks net some of or most of loyalty expenses, (2) debit interchange for TD’s US business is included in results, (3) some but not all banks include foreign exchange-related revenues on credit card transactions.

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Exhibit 64: Card Service Revenues

Card Service Revenues ($, millions) % of Total Revenues % of Pre-tax Income 2011 2012 Q3/13 2011 2012 Q3/13 2011 2012 Q3/13 BMO 689 708 193 4.9% 4.4% 4.8% 17.3% 13.8% 13.5% BNS1 455 580 133 2.6% 2.9% 2.4% 6.7% 7.2% 6.0% CM 609 619 151 4.9% 4.9% 4.6% 16.0% 15.3% 14.1% NA 116 113 32 2.4% 2.1% 2.4% 6.6% 5.3% 6.2% TD2 959 1,039 368 4.4% 4.5% 6.2% 13.5% 14.2% 21.6% RY 882 920 251 3.2% 3.1% 3.5% 9.8% 9.5% 9.3% Total 3,710 3,979 1,128 3.8% 3.7% 4.1% 11.5% 10.9% 11.7%

(1) Scotiabank's card service revenues are presented net of cards expense to align with disclosure at the other Canadian Banks. (2) TD Bank’s Q3/13 revenues were negatively impacted by a $565 million charge related to strengthening reserves and increased claims in the banks insurance business. Excluding the insurance charges taken in Q3/13, card services revenue as a % of total revenues was 5.7% and as a % of pre-tax income was 16.2%. TD Bank’s card service revenues include fees from the acquired Target credit card book in the US beginning in Q2/13. Source: Company reports, RBC Capital Markets

Retail loans are mostly funded with retail deposits Now that we have detailed the asset side of the balance sheet, a discussion on funding is required.

The majority of the banks’ loan portfolios are funded with deposits, which exist primarily to support banks’ loan books (although banks also make money on deposit accounts by charging monthly fees, which can be $10–15, and fees for unlimited transactions, up to $30 per month for premium accounts, and less than $5 for limited transaction accounts). The profitability of deposits tends to be higher when short-term interest rates are higher because a zero-cost deposit can be reinvested at a higher rate (Exhibit 65).

Ideally, retail loan portfolios would be funded entirely with personal deposits because personal deposits are, in general, less expensive than wholesale funding and “stickier”. Deposits of up to $100,000 are insured by the CDIC21, meaning that even in the event of a bank failure, depositors should be able to recoup their money. This guarantee limits the need for banks to pay a high rate on retail term deposits but does not help as much for wholesale deposits, which tend to be larger.

 Retail loan portfolios, which include small business loans, are just under 50% funded with personal deposits, ranging from about 72% at TD Bank to about 42% at Scotiabank.

If consistently disclosed, it would be fair to include small-business deposits as well as some commercial deposits as “core”, sticky, low-cost deposits, but the disclosure is inconsistent. We attempt to estimate what those are, and directionally, it would boost how much of retail loan portfolios are funded with core deposits by about 25%. Only TD’s retail loan book would be fully funded with core deposits.

 This shortfall in funding did not always exist, as Canadian retail loans were fully funded with personal deposits until 2002. The explosion in popularity of mutual funds in the 1990s and a gradual decline in interest rates led to disintermediation of savings from retail investors (i.e., Canadians took money out of GICs and savings accounts and

21 Canadian dollar savings and chequing accounts, and GICs of five years or less are insured by CDIC up to $100,000. Customers can have up to six-accounts insured per institution (one account in their name, one joint account, one trust, one RRSP, one RRIF, and/or an account held for paying realty taxes on mortgage payments). CDIC is a federal corporation. September 18, 2013 86 Canadian Bank Primer, Sixth Edition

invested the money in mutual funds, including money market funds). The trend reversed in 2008–2009 with risk averse individuals choosing to shift assets out of equities or mutual funds and to the relative safety of bank deposits, but that changed again in 2010 and 2011 because equity markets recovered (Exhibit 66).

Exhibit 65: Retail loan books are no longer fully funded with personal deposits, which have declined relative to loans

Personal Deposits as % of Total Loans Personal Deposits as % of Total Deposits (Annual since 1986) (Annual since 1986) 65% 25% 55%

60% 21% 50%

55% 17% 45%

50% 13% 40%

45% 9%

35%

40% 5% 86 88 90 92 94 96 98 00 02 04 06 08 10 12 30% Personal Deposits % Total Loans (LHS) 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Personal Deposits % Total Loans + Securitized Assets (LHS) Securitized Assets as % Loans (RHS) Personal Deposits as % Total Deposits

Total Big Six; includes international deposits and international retail loans. Source: Company reports, RBC Capital Markets

Exhibit 66: Mutual fund AUM have grown faster than personal deposits in the last 15 years

Mutual Fund AUM vs. Personal Deposit Growth (Annual since 1997)

30%

25%

20%

15%

10% YoY Growth YoY 5%

0% 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

-5%

-10%

Mutual Fund AUM Personal Deposits

Total Big Six banks; includes international deposits and international retail loans. Source: Company reports, RBC Capital Markets

The least expensive form of retail deposits is transaction accounts. Customers receive low interest rates on their cash balances, and monthly fees add to the profitability of those accounts. Furthermore, transaction accounts are usually sticky and along with mortgages are, in our view, the most important product from which a bank could cross-sell. Two key developments outside disintermediation toward mutual funds have hurt growth in transaction account balances in the last 15 years:

 Banks have been forced to introduce high-yield savings accounts as an answer to competition from new virtual entrants, as well as money market funds. Those accounts

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pay much higher interest rates than transaction accounts. Now that banks have introduced high-yield savings accounts, their popularity have grown.  The increased popularity of internet banking has given customers the ability to better manage their cash balances. We do not know how many customers take advantage of this, but at the click of a mouse, a customer can shift money from a high-interest account into a transaction account the day before they have a cash outlay. Likewise, an inflow in a transaction account (normally from payroll) can immediately be transferred into a savings account using the Internet.

Retail funding has become more expensive than in the past and we expect pricing to remain aggressive as banks look to build their retail deposit bases ahead of the implementation of new liquidity requirements.

Wholesale funding sources are typically pricier than retail because of buyer sophistication, although they have lower distribution expenses (i.e., a retail branch, ATM network, and a robust Internet platform need to be maintained for retail deposits—i.e., transaction accounts—whereas infrastructure required to gather wholesale deposits is limited). The availability of wholesale funds can be more volatile than with retail funding, so banks need to have access to multiple sources of wholesale funds. Canadian banks have become more dependent on wholesale funding since the early 1990s.

 Banks that are more dependent on wholesale funding are more susceptible to seeing that funding dry up. A “run” on a bank can bankrupt it even if the credit quality of its assets is in good shape or capital ratios look healthy (Lehman Brothers, Bear Stearns, and Northern Rock are examples of firms that failed because their access to funding dried up, not because they incurred losses on assets that bankrupted them). Canadian banks have access to multiple sources of funding, and they were not affected as severely by the liquidity crunch in 2008 and early 2009 as other institutions around the world were.

Securitizations are another source of funding available for banks that do not have enough retail deposits to fund their retail-lending portfolios, those who wish to diversify their sources of funding or to free up capital, or those looking to take advantage of a fairly inexpensive source of funds.

 Securitizations have grown in popularity for Canadian banks since 2003, particularly for mortgages, but are down from their 2009 highs (Exhibit 67).  The idea behind a securitization is for a bank to transfer most of the credit risk to buyers (securitized assets had previously been taken off bank balance sheet under Canadian GAAP but not under IFRS as discussed below). Banks typically continue to service the loan portfolios (i.e., they collect interest payments, principal prepayments, go after delinquent accounts, print statements, etc.) in return for a fee, which is paid from the securitization vehicle.  The overwhelming majority of bank loans that are securitized are mortgages. The Government of Canada indirectly supports the securitization of mortgages because mortgages securitized by banks are insured by either CMHC, Genworth MI Canada, or Canada Guaranty.  The volatility in the cost of securitizing mortgages is, therefore, driven more by five-year Government of Canada rates than by the banks’ cost of funds. Banks tend to securitize more mortgages when the spread between market mortgage rates and mortgage bonds is higher, or when their own cost of funds is higher than normal. The first half of fiscal 2009, for example, was a period in which banks securitized more mortgages than normal, as their cost of funds was high relative to government rates. (Exhibit 68). September 18, 2013 88 Canadian Bank Primer, Sixth Edition

 The accounting for securitizations changed materially as banks transitioned to IFRS in Q1/12, which brought many securitized mortgages back on balance sheet and led to higher stated assets and liabilities and lower retained earnings at transition. Positively, banks have greater ongoing interest income from the assets that were brought on balance sheet. We believe, however, that the economics of securitizations and the timing of securitizations will be driven by similar dynamics as in the past: 1) aggregate funding needs; and 2) the relative attractiveness of securitizing compared with other funding alternatives.

Exhibit 67: Mortgage securitizations have become popular since 2003 but are down from their highs

Securitized Mortgages as % of Total Mortgages Securitized Assets as % of Total Loans (Quarterly since 2000) (Quarterly since 2000) 35% 15%

30%

13%

25%

20% 10%

15%

10%

5% 5% 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13

Securitized Mortgages as % Total Mortgages Securitized Assets as % Loans

Total Big Six; total mortgages include securitized mortgages; total loans include securitized loans. Source: Company reports, RBC Capital Markets

Exhibit 68: Mortgage rates relative to Canada mortgage bonds have risen recently

Bank 5-Year Mortgage Rate (Fixed)

550 500 450 400 350

300 Spread(bps) 250 200 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Canada 5-year fixed rate mortgage vs. 5-year CMB

Canada 5-year fixed rate mortgage vs. 5-year Government of Canada bond

Source: Bloomberg, RBC Capital Markets

Covered bonds are a type of funding source introduced to Canadian banks in 2007. Today, the Big Five banks each have between $3 billion and $16 billion of covered bonds outstanding, which represents between 1.2% and 3.5% of total assets. Covered bonds, are debt instruments that are secured by a priority claim on collateral of high-quality on-balance sheet assets. The assets are typically a pool of prime residential mortgages or public-sector debt that remains on the issuer’s balance sheet but acts as collateral to “cover” the bonds. OSFI allows banks to issue covered bonds up to 4% of total assets. September 18, 2013 89 Canadian Bank Primer, Sixth Edition

Insured mortgages have helped Canadian banks keep funding costs low Banks insure mortgages in order to access cheap wholesale funds—predominantly through the creation of National Housing Act Mortgage Backed Securities (NHA MBS). Insured mortgages can serve as collateral for secured funding purposes, predominantly through the creation of NHA MBS. Historically, Canadian banks have “bulk insured” pools of low LTV mortgages to create NHA MBS, which can then serve as collateral to raise cost-efficient wholesale funds through: (1) the Canada Mortgage Bond program and (2) direct market placement of NHA MBS. NHA MBS was also used during the financial crisis to fund through the Bank of Canada initiated Insured Mortgage Purchase Program—a temporary program (that ended in 2010) launched to support the banks through a period of acute funding pressure. Prior to 2013 insured mortgages also comprised the bulk of Canadian bank covered bond pools.

Raising wholesale funds backed by insured mortgages has been the most cost-efficient source of wholesale funding for the Canadian banks. As shown in Exhibit 69, funding alternatives backed by insured mortgages, either through the Canada Mortgage Bond program or directly through NHA MBS, has saved the banks 25–60 basis points over senior unsecured funding. Exhibit 70 illustrates bank capital structures with their associated costs— as would be expected, insured mortgage backed sources of funding are the most cost- efficient sources of wholesale funds.

Exhibit 69: Mortgage backed funding structures are cheaper than unsecured funding

CMB 5-year 350 MBS 975 5-year 325 300 Snr Bank Notes 275 250 225 200 175 150 125 100

Credit Spread (vs Spread Credit GoC curve) 75 50 25

Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13

Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-06

Source: RBC Capital Markets

With a view to curtailing the socialization of bank credit risk, the federal government is: (a) restricting the ability of banks to “bulk insure” mortgages; and (b) eliminating the use of insured mortgages in bank covered bond pools. Theoretically, this should restrict the ability of banks to fund on a secured basis and raise their cost of funding. With CMHC approaching its $600 billion limit on the amount of insurance outstanding, the federal government has directed the banks to avoid “bulk insurance” so as to reserve the remaining capacity for high LTV home buyers. In a related move, the government’s revised covered bond legislation prohibits banks from including insured mortgages in their covered bond

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pools (to act as collateral). These moves should limit the banks’ ability to fund using insured mortgages, which, in theory, should pressure funding cost levels.

We think that the ultimate cost of restricting the amount of “bulk insurance” should be modest for the large banks. Our view is based on the following two factors: 1) the banks are sitting on a stock pile of NHA MBS that has not yet been used for funding purposes; and 2) alternative sources of funding should prove only modestly more expensive. Most importantly, the banks continue to have the capacity to fund through the CMB program as well as through direct issuance of NHA MBS. As of June 30, 2013, OSFI data shows the Big Six banks having $170 billion of NHA MBS “pooled and unsold”. This unsold balance of NHA MBS represents ~56% of the total current NHA MBS outstanding for these banks (it is also worth noting that as mortgages pay off, additional capacity is freed up). Secondly, the banks, as a group, have alternative sources of funding that remain cost-effective. Specifically, we note that bonds issued through Royal Bank’s uninsured covered bond program traded only ~10 basis points wider than peer bank insured programs. Furthermore, alternative sources of secured funding could emerge as needed, e.g. the Canadian market has, in the past, supported a non-prime RMBS market.

Exhibit 70: Mortgage backed funding structures are cheaper than unsecured funding

Funding

Gov’t NHA MBS Guaranteed 65bps (975)

Covered Bonds / Secured Funding 80bps / ABS 85bps

Insured Deposits Deposit Notes 95bps Rank Ahead of Deposit Notes Capital

Weaker Capital / More Debt-Like / Higher Credit Ratings

Subordinated Sub-debt Debt (NVCC) Tier 2 Capital Less Loss Shorter Dated Mandatory with NVCC Absorbing – i.e. Charges (i.e. non- yet to be Gone Concern deferrable priced Basis coupons)

Hybrid Hybrid Instruments instrument (NVCC) Tier 1 Capital with NVCC yet to be More Loss Longer Dated / Free of priced Absorbing – Undated Mandatory Going Concern Charges Common Shares Tangible Basis / Retained Common Equity Earnings (Tier 1) Stronger Capital / More Equity-Like / Lower Credit Ratings

Source: RBC Capital Market

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SECTION 5: Wholesale banking is banks’ second-largest division Wholesale banking accounts for 15–40% of income in normal years, depending on the bank (Exhibit 71). Wholesale (or capital markets) divisions deal with corporate and institutional clients, and revenue-generating activities include corporate lending, trading, underwriting, and advisory (i.e., M&A). Most banks have had a merchant banking or private-equity arm as well, but those were/are generally small and have been, or are being, de-emphasized (largely due to regulatory changes). Approximately 30–50% of Canadian banks’ wholesale revenues come from trading, while 20–40% is from advisory, underwriting, and other market activities, and 10–40% from corporate lending.

Wholesale banking is the most difficult division for analysts to forecast because of the volatility of earnings as well as opacity of certain activities. Exposure to non-Canadian revenue sources also makes it difficult to rely on Canadian industry data and trends to forecast revenues.

Investors normally value wholesale earnings at lower multiples than retail banking or wealth management earnings. This is due to the difficulty that investors have in forecasting wholesale revenues, as well as the fact that more accidents (expected and unexpected) occur in wholesale divisions than in retail banking or wealth management divisions. Also, large loan losses normally happen in wholesale divisions (although for Canadian banks, that was not the case in the most recent credit cycle), as do trading losses and large-scale fraud. Those events are infrequent, but investors, nonetheless, remember the times that they occur and hold back from assigning higher, retail-like, multiples to wholesale divisions. Furthermore, wholesale divisions have higher capital requirements than in the past, and than other divisions such as wealth management which is negative for valuation multiples.

Wholesale banking divisions have become more diversified than in the past, and while forecasting individual line items is nearly impossible, it would be unusual for all businesses to do poorly (or very well) at the same time in a normal environment. Furthermore, wholesale banking earnings should be “earlier cycle” than traditional banking earnings. Having wholesale banking divisions has increased revenue volatility for banks, but it has also lowered exposure to PCL in down cycles. Having larger wholesale banking divisions has made banks more exposed to securities writedowns than in the early 1990s and 1980s (which was a negative in 2007 and 2008), but as the credit cycle played out and loan losses rose, the banks had revenue sources that they did not have in the past to offset rising loan losses. The banks’ experience in 2009 was an illustration of this new paradigm as higher retail and commercial loan losses were in large part offset by very strong capital markets revenues, especially trading.

Broadly, we are more positive on the outlook for underwriting, advisory, and corporate lending than trading in upcoming years, but an improvement in risk appetite is necessary for those businesses to improve. On the investment banking side, we think that companies held back on investment and M&A activities during the most recent financial crisis and recession and subsequent period of slow and uncertain growth. As well, many companies are underlevered and have access to inexpensive debt financing by long-term standards. On the trading side, capital requirements have increased22 (and will increase further) and we believe

22 The new capital requirements that are specific to wholesale markets (Basel 2.5, which went into effect in Q1/12 and the counterparty credit risk component of Basel III, which is to be phased in beginning in January 2014) should affect trading businesses more than lending and underwriting businesses and, within trading, should affect fixed income businesses more than equities and foreign exchange businesses. Areas of fixed income that will likely be particularly affected are structured products and the trading of non-investment grade securities. Proprietary trading and derivatives trading should see capital requirements increase much more than client-driven agency trading. September 18, 2013 92 Canadian Bank Primer, Sixth Edition

that spreads in “plain vanilla” fixed income and derivatives businesses could decline as more of that business is traded electronically, more is moved to exchanges, and more is cleared centrally.23

The Canadian banks are leaders in Canadian capital markets, with foreign competition higher in some areas, including advisory businesses (Exhibit 72 to Exhibit 75).

In the last few years, Canadian banks typically led the M&A league tables with three or four of the top five spots. Equity underwriting was led by Canadian dealers, with only one or two foreign players in the top 10 market share. Debt underwriting league tables have two or three foreign dealers in the top 10, but the Big Six Canadian banks usually rank at the top of the list and account for about 90% market share. The Canadian banks also have six of the top eight market share positions for equity trading according to the TSX.(Exhibit 75)

Exhibit 71: Wholesale divisions normally account for about 20-30% of total earnings

Wholesale Earnings as % of Total Earnings* 2005 - 2012 2005 2006 2007 2008 2009 2010 2011 2012 Median BMO 36% 32% 20% 32% 52% 31% 34% 26% 32% BNS 29% 30% 28% 26% 43% 33% 25% 25% 29% CM n.m. 19% 14% n.m. n.m. 15% 20% 19% 19% NA 29% 34% n.m. 52% 65% 48% 36% 28% 36% RY ** 20% 29% 24% 26% 34%** 30% 20% 22% 25% TD 19% 14% 21% 2% 38% 19% 14% 14% 17% Median 29% 29% 21% 26% 43% 30% 23% 23% 27%

* Reported Earnings: Include special items; n.m. = not meaningful due to an extraordinary event. ** RY’s 2009 total earnings used were cash earnings, which exclude a $1 billion goodwill writedown. RY’s wholesale earnings as a % of total reported earnings would otherwise be 50%. Source: Company reports, RBC Capital Markets

Exhibit 72: Canadian banks among the top rankings in M&A league tables1

2010 2011 2012 H1/2013 Market Market Market Market Rank Advisor Share (%) Advisor Share (%) Advisor Share (%) Advisor Share (%) 1 Goldman Sachs & Co 19.3% CIBC World Markets inc 23.2% RBC Capital Markets 24.4% RBC Capital Markets 47.8% 2 CIBC World Markets inc 18.4% TD Securities Inc 22.2% BMO Capital Markets 21.8% Goldman Sachs & Co 30.4% 3 RBC Capital Markets 18.3% BMO Capital Markets 20.8% Bank of America Merril Lynch 20.3% Citi 28.5% 4 Morgan Stanley 17.5% Goldman Sachs & Co 17.7% TD Securities Inc 19.5% BMO Capital Markets 26.9% 5 BMO Capital Markets 16.6% RBC Capital Markets 17.5% Goldman Sachs & Co 15.9% CIBC World Markets inc 21.9% 6 UBS 14.7% Morgan Stanley 16.2% Scotiabank 15.3% Evercore Partners 14.8% 7 JP Morgan 12.9% JP Morgan 13.6% Credit Suisse 13.3% TD Securities Inc 12.7% 8 TD Securities Inc 12.8% Bank of America Merril Lynch 9.7% CIBC World Markets inc 10.4% Scotiabank 10.7% 9 Bank of America Merril Lynch 10.7% Citi 6.0% National Bank Financial 10.1% Canaccord Genuity 9.1% 10 Citi 9.9% Canaccord Genuity 5.6% JP Morgan 8.2% Bank of America Merril Lynch 8.5%

1 Includes completed rank eligible mergers, acquisitions, repurchases, spin-offs, self-tenders, minority stake purchases, and debt restructurings; Any Canadian involvement; Market shares are by volume and include double counting of volumes for brokers. Source: Thomson Reuters, RBC Capital Markets

23 We would expect an offset from increased volumes (as long as markets are supportive of higher client activity) but probably not enough to offset lower margins, and the keys to success in that business will likely shift from quality sales and trading individuals to quality information technology platforms (although this transition could progress over many years). September 18, 2013 93 Canadian Bank Primer, Sixth Edition

Exhibit 73: Foreign competition is sparse in equity underwriting

2010 2011 2012 H1/2013 Market Market Market Market Rank Advisor Share (%) Advisor Share (%) Advisor Share (%) Advisor Share (%) 1 BMO Capital Markets 10.8% TD Securities Inc 16.9% RBC Capital Markets 17.2% Goldman Sachs & Co 16.5% 2 GMP Capital Corp 10.5% RBC Capital Markets 12.7% Scotiabank 16.6% BMO Capital Markets 16.1% 3 RBC Capital Markets 10.3% BMO Capital Markets 10.6% BMO Capital Markets 14.8% RBC Capital Markets 14.6% 4 CIBC World Markets inc 9.6% CIBC World Markets inc 10.2% TD Securities Inc 11.6% TD Securities Inc 12.0% 5 TD Securities Inc 8.0% Scotiabank 7.4% CIBC World Markets inc 8.9% Scotiabank 6.0% 6 Canaccord Genuity 7.2% Canaccord Genuity 5.5% National Bank Financial 4.2% Canaccord Genuity 4.6% 7 Scotiabank 4.7% National Bank Financial 5.0% GMP Capital Corp 3.4% CIBC World Markets inc 4.3% 8 National Bank Financial 3.5% GMP Capital Corp 4.1% Canaccord Genuity 3.1% National Bank Financial 4.3% 9 Morgan Stanley 3.5% Cormarck Securities Inc 3.3% Cormarck Securities Inc 2.2% GMP Capital Corp 4.2% 10 Macquarie 3.4% Peters & Co Ltd 2.5% Dundee Securities Corporation 1.6% Peters & Co Ltd 2.1%

Market share based on Canadian dollar deal proceeds for all Canadian equity and equity-related transactions including IPOs, follow-on offerings, PIPES, accelerated book builds, block trades (with certain restrictions), and convertible bonds Source: Thomson Reuters, RBC Capital Markets

Exhibit 74: Debt underwriting league tables led by Canadian dealers

2010 2011 2012 H1/2013 Market Market Market Market Rank Advisor Share (%) Advisor Share (%) Advisor Share (%) Advisor Share (%) 1 RBC Capital Markets 23.6% RBC Capital Markets 23.5% RBC Capital Markets 24.3% RBC Capital Markets 21.4% 2 TD Securities Inc 18.4% TD Securities Inc 18.3% National Bank Financial 18.5% TD Securities Inc 19.3% 3 CIBC World Markets inc 15.6% CIBC World Markets inc 17.7% CIBC World Markets inc 15.6% CIBC World Markets inc 17.9% 4 National Bank Financial 13.2% National Bank Financial 17.7% TD Securities Inc 14.1% National Bank Financial 15.1% 5 BMO Capital Markets 9.8% BMO Capital Markets 12.2% BMO Capital Markets 12.4% BMO Capital Markets 11.5% 6 Scotiabank 8.6% Scotiabank 7.7% Scotiabank 10.3% Scotiabank 9.2% 7 Bank of America Merril Lynch 4.8% Bank of America Merril Lynch 1.1% Bank of America Merril Lynch 1.9% Bank of America Merril Lynch 3.2% 8 Desjardins Securities 1.9% HSBC Holdings 0.3% HSBC Holdings 0.8% HSBC Holdings 0.5% 9 Bank of Canada 1.8% Desjardins Securities 0.3% Desjardins Securities 0.7% Desjardins Securities 0.4% 10 HSBC Holdings 1.4% Laurentian Bank 0.3% GMP Capital Corp 0.4% Casgrain & Companie Ltee 0.4%

Market share is based on Canadian dollar amounts for Canadian corporate and government debt, excluding self-led transactions Source: Thomson Reuters, RBC Capital Markets

Exhibit 75: Equity trading share (year-to-date ending June 2013)

Broker Buy Market Share 1 Broker Sell Market Share 1 CIBC World Markets Inc. 23.80% CIBC World Markets Inc. 23.28% TD Securities Inc. 14.25% TD Securities Inc. 14.89% RBC Capital Markets 10.09% RBC Capital Markets 9.87% BMO Nesbitt Burns Inc. 8.85% BMO Nesbitt Burns Inc. 8.28% Merrill Lynch Canada Inc. 4.97% Merrill Lynch Canada Inc. 5.00% Instinet Canada Ltd. 4.72% Instinet Canada Ltd. 4.73% Scotia Capital Inc. 4.72% Scotia Capital Inc. 4.71% National Bank Financial Inc. 4.04% National Bank Financial Inc. 4.20% Morgan Stanley Canada Ltd. 3.02% Morgan Stanley Canada Ltd. 3.15% UBS Securities Inc. 2.13% UBS Securities Inc. 2.14%

(1) Market share by value traded Source: TSX, RBC Capital Markets

Advisory and underwriting have low capital requirements Banks provide advice and support to companies and governments looking to raise capital (equity or debt), and to companies looking to enter into acquisitions or divestitures. Approximately 20–40% of Canadian banks’ wholesale revenues come from advisory and underwriting businesses, and other fee-generating activities.

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Banks advise companies during the entire process of a merger or acquisition and are paid an advisory fee. M&A is a highly profitable source of revenues because capital requirements are zero, and banks receive fees based on the value of transactions, which can be large (i.e., a large M&A transaction will tend to have a much higher value than a large initial or secondary public offering). Furthermore, being an advisor on an M&A transaction (particularly on the buyer’s side) could bring many types of other business, particularly financing-related. M&A fees would be about 0.15–0.5% of transaction value for large transactions and can range between 1.0% and 1.5% for smaller ones.

Banks also advise and support companies and governments in their capital-raising activities by helping them structure, price, market, and distribute equity and debt offerings. Banks can earn a fee based on transaction size in “best-effort” transactions where the underwriters do not have risk, or they can buy the issue from an issuer in a bought deal (which guarantees the issuer a rapid inflow of funds) at a discount and attempt to make a profit by redistributing the shares in the secondary market.

 Fees for equity underwriting range between 4% and 6% while fees for debt underwriting are 0.35–0.5% on investment grade issues and 1–1.5% for non-investment grade issues.

Forecasting advisory revenues is a difficult exercise because revenues tend to be very volatile, and an outsider is not privy to the transactions that issuers, underwriters, and advisors are contemplating (that would be insider information). Generally, equity and debt issuance, as well as M&A, are more frequent in “good times”. Companies have an easier time raising money if markets are strong and will have more comfort in initiating an M&A transaction if they are confident about their own and the seller’s prospects. We therefore expect to see more M&A activity and capital issues in times of: 1) higher GDP growth; 2) stronger equity markets; and/or 3) declining interest rates and/or credit spreads.

 Underwriting and M&A volumes as well as trading volumes in Canada generally grew from 2002 until the market turmoil hit in mid-2007 and then declined in 2008 with a slow return to pre-crisis volumes by 2011-2012. For example, debt underwriting of Canadian corporates went from a peak of $87 billion in volumes in 2006 down to $56 billion in 2009, and has since recovered to break through the pre-crisis peak with $89 billion in 2012. Completed M&A transactions reached $304 billion in 2006 before dropping to $129 billion in 2009, and have since risen to $174 billion in 2012. (Exhibit 77).  Canadian investment dealers’ advisory and underwriting businesses were helped by strong commodity markets until mid-2007, which led to frequent underwriting and M&A opportunities in Canada during that time (M&A business was driven less by private equity firms than in the US). Until recently, commodity markets improved from the slowdown in 2008 and 2009, which again led to higher activity.  Total financings (including IPOs, secondary, and supplementary financings) on the TSX were $42–46 billion in 2010 and 2011. Financings grew from $39 billion in 2004 to $48 billion in 2007 as the S&P/TSX Composite Index was generally rising, but it declined in 2008 to $35 billion as the index fell. The need for corporate recapitalizations and financings along with a recovery in investor optimism led to $60 billion in issuance in 2009, followed by continued issuance in the $44–$49 billion range in 2010 to 2012 (Exhibit 77).

From a forecasting perspective, we find the following useful to think about:

 M&A volumes have been volatile with a link to the change in GDP growth observable in the past decade with stronger M&A volumes in improving economic times, which September 18, 2013 95 Canadian Bank Primer, Sixth Edition

would likely bolster buyers’ confidence levels (Exhibit 76). M&A volumes were low globally and in Canada from 2008 to 2009. We believe the medium-term outlook for the advisory business is positive as many companies held back on pursuing M&A in an uncertain environment, more companies find organic revenue growth harder to come by than in the past, many companies are underlevered and can increase balance sheet leverage, and the cost of debt financing is low by long-term standards.

Exhibit 76: M&A activity generally picks up when GDP growth outlook is strong

120,000 5 1,800 5 4 4 1,600 100,000 3 3 1,400 2 2 1,200 80,000 1 1 1,000 0 60,000 0 800 -1 -1 -2 40,000 600 -2 -3 400 -3 -4 20,000 200 -5 -4

- -6 - -5

07 08 09 10 11 12 07 08 09 10 11 12

07 08 09 10 11 12 13 07 08 09 10 11 12 13

------

Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul

Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar Mar

Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov Nov

MSCI World Index M&A Transaction Value Global World GDP (YoY %) (RHS) S&P TSX Index (re-based) M&A Transaction Value Canada Canada GDP

Source: Bloomberg, World Bank, RBC Capital Markets Research

 Corporate debt-underwriting volumes have generally increased when credit spreads tightened, and M&A volumes and equity offerings have also risen (although not always) in stronger equity markets and economies in Canada. We expect the absolute level of interest rates to also have an effect on debt underwriting volumes, with increasing rates being negative. Corporate debt underwriting volumes in Canada were weak in 2008 and 2009 as many companies were cautious on capital expenditures and investment, but activity improved in 2010, and we believe that it will remain strong going forward as companies catch up on projects that were held back. Many companies are underlevered and have access to inexpensive debt financing.  Government debt underwriting revenues will be based on financing needs. The Canadian government went through a long period of surpluses, which reduced borrowing requirements in the years leading up to 2007. Fiscal policies have changed since 2007, and it is likely that deficits will continue to be the new norm, at least in the short term, which will lead to continued high levels of government debt issuance to finance the deficits, in our view.

Exhibit 77: Volumes tend to follow market direction

31-Dec-02 31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10 31-Dec-11 31-Dec-12 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Debt underwriting YoY change (Canadian) (7)% 55% 11% 24% 22% (8)% (27)% (3)% 40% 0% 13% Credit spread YoY change (average) 9% (14)% (23)% (17)% (5)% 9% 105% 7% (30)% 2% 9% M&A volumes in Canada YoY change (32)% (19)% 68% 44% 110% (7)% (43)% (20)% 14% 7% 11% Equity offerings - Canadian corporates YoY change 76% 23% 38% (20)% 13% 23% (8)% 56% (20)% (3)% (10)% Total financings (IPO, secondary, supplementary, $B) 25,965 29,145 39,410 43,966 41,441 47,614 35,312 60,028 44,149 45,763 48,756 TSX index YoY change (average) (14)% 24% 12% 22% 15% 7% (35)% 31% 14% (11)% 4% GDP growth % YoY 2.9% 1.9% 3.1% 23.4% 2.7% 2.1% 1.1% (2.8)% 3.2% 2.6% 1.8%

Source: Bloomberg, Thomson, TSX, Statistics Canada, RBC Capital Markets

September 18, 2013 96 Canadian Bank Primer, Sixth Edition

Expenses have a good degree of flexibility because a significant component is made up of compensation-related costs, much of which are variable. We estimate that 55–70% of total expenses in wholesale divisions represent compensation-related expenses. Expenses typically account for 50–60% of revenues, depending on revenue mix; corporate lending has much lower operating expenses compared to other areas of wholesale banking (but capital requirements are higher24), for example. And within trading, we believe that the equities business has higher operating expenses than the fixed income business (again, capital requirements are “opposite”).

 Global investment dealers have higher expense ratios, with total ratios in the 60–75% range including compensation ratios in the 30–50% range. Part of that difference would be “real”, and part would be reflective of Canadian banks having corporate costs spread over a more diversified business mix. Also, not all global investment dealers include corporate lending as part of their wholesale divisions, which would help Canadian banks’ relative expense ratios.

Trading businesses are volatile from quarter to quarter Banks generate approximately 5–10% of their total revenues from trading operations (or 30–50% of their wholesale revenues), representing mostly client-driven trading and some proprietary trading (Exhibit 78). Trading revenue reported on the income statement arises if a bank assumes risk; risk-free agency commissions (executing an equity block trade for two clients as an example) are booked as commission income. Trading revenues include interest and dividends related to trading assets and liabilities, as well as realized and unrealized gains or losses on trading securities and trading derivative financial instruments. Trading revenues are disclosed separately as net interest income and non-interest income.

The majority of trading revenues are generated in banks’ fixed income and foreign exchange businesses. Approximately 55–65% of revenues come from fixed income, currencies, and commodities (with fixed income the largest then currencies) and 35–45% from equities. The equity component of trading revenues would refer to derivatives activity or liability trading; as stated above, trades executed on an exchange on behalf of clients are booked as commission income.

Most people reading this primer are likely equity analysts who operate in a world where most stock purchases or sales are done on a commission basis, therefore having an agency relationship with investment dealers. Outside equity trading, relationships between the buy side and investment dealers are different. In fixed income, foreign exchange, commodity, and options businesses, investment dealers operate as market makers and aim to capture the spread between what buyers are willing to pay and what sellers are willing to receive. The profitability of trading businesses, simplistically stated, is a function of volumes and spreads, and any gains or losses on the inventory needed to support market making. Bid-ask spreads vary based on competition, capital levels in the industry or a specific product line, volatility in the price of the security being traded (higher volatility normally means higher spread), and liquidity (more liquid assets will trade at narrower spreads). Bid-ask spreads are generally not available public sources of information, but, anecdotally, they rose materially in late 2008 and early 2009 before trending back down to more normal levels. Bloomberg provides information on some asset classes (Exhibit 79), which directionally supports our view.

24 Capital requirements for trading businesses have increased, and will likely increase further, thereby increasing the relative appeal of corporate lending. September 18, 2013 97 Canadian Bank Primer, Sixth Edition

Exhibit 78: Trading contribution to total revenues rose in 2009 but has declined since

Trading Revenue as % of Total Revenue* (Quarterly since 2000) 16%

14%

12%

10%

0% 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13

Trading Revenue % Total Revenue 4 Quarter Moving Average

* Includes special items. Median of Big Six Banks. Source: Company reports, RBC Capital Markets

Exhibit 79: Bid-ask spreads have declined since early 2009

270

220

170

120 Indexed at t = 100 = t at Indexed

09 10 12 11 13

09 11 13 10 12

08 10 12 09 11

- - - - -

Oct Oct Oct Oct Oct

Jun Jun Jun Jun Jun

Feb Feb Feb Feb Feb

5y Euro Swap Euro Currency US Govt 10 Yr Bond

Source: Bloomberg, RBC Capital Markets Research

September 18, 2013 98 Canadian Bank Primer, Sixth Edition

Trading revenues are notoriously opaque25 and volatile, so investors have been unwilling to reward banks with fast-growing trading operations, although trading revenues have benefited from increased diversification in the last decade. Expansion into product areas such as commodities and energy, higher use of electronic trading, increased emphasis on derivatives, as well as volatile currency and energy markets have helped expand trading revenue beyond the traditional areas of interest rates, equities, foreign exchange, and credit.

 For example, notional amounts of interest rate and currency swaps grew from less than US$1 trillion in 1987 to US$29 trillion in 1997, $382 trillion in 2007, and US$567 trillion in 2011. Credit-default swaps grew from just less than US$1 trillion in 2001 to US$17 trillion in 2005 and US$29 trillion in 2011 (down from US$62 trillion in 2007). Equity derivative notionals were US$3 trillion in 2002 and US$6 trillion in 2011 (down from US$10 trillion in 2007).

Exhibit 80: Notional derivatives are up from 2009

Global OTC Derivatives Market Volume

800,000 30,000 4,500 707,569 700,000 4,000 647,762 638,928 632,579 25,000 603,900 601,048 594,553 582,655 3,500 600,000 20,000 3,000 500,000 2,500

400,000 15,000

$bn $bn $bn 2,000 300,000 10,000 1,500 200,000 1,000 5,000 100,000 500

0 0 H1 2009 H2 2009 H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 H2 2012 H1 2009 H2 2009 H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 H2 2012 Notional Amounts Outstanding Gross Market Value Gross Credit Exposure

$bn H1 2009 H2 2009 H1 2010 H2 2010 H1 2011 H2 2011 H1 2012 H2 2012 H2 '12/H1 '12 H2/H2 Notional Amounts Outstanding 594,553 603,900 582,655 601,048 707,569 647,762 638,928 632,579 -1.0% -2.3% Forex 48,732 49,181 53,125 57,798 64,698 63,349 66,645 67,358 1.1% 6.3% Interest rate contracts 437,228 449,875 451,831 465,260 553,880 504,098 494,018 489,703 -0.9% -2.9% Equity contracts 6,584 5,937 6,260 5,635 6,841 5,982 6,313 6,251 -1.0% 4.5% Commodity contracts 3,619 2,944 2,852 2,922 3,197 3,091 2,993 2,587 -13.6% -16.3% CDS 36,098 32,693 30,261 29,898 32,409 28,633 26,931 25,069 -6.9% -12.4% Unallocated 62,291 63,270 38,327 39,536 46,543 42,609 42,028 41,611 -1.0% -2.3% Gross Market Value 25,298 21,542 24,673 21,148 19,518 27,285 25,392 24,740 -2.6% -9.3% Forex 2,470 2,070 2,524 2,482 2,336 2,555 2,217 2,304 3.9% -9.8% Interest rate contracts 15,478 14,020 17,533 14,608 13,244 20,001 19,113 18,833 -1.5% -5.8% Equity contracts 879 708 706 648 708 679 645 605 -6.2% -10.9% Commodity contracts 682 545 457 526 471 487 390 358 -8.2% -26.5% CDS 2,973 1,801 1,666 1,351 1,345 1,586 1,187 848 -28.6% -46.5% Unallocated 2,816 2,398 1,788 1,532 1,414 1,977 1,840 1,792 -2.6% -9.4% Gross Credit Exposure 3,744 3,521 3,578 3,342 2,971 3,912 3,668 3,626 -1.1% -7.3%

Source: BIS, RBC Capital Markets Research

25 Not only are sources of trading revenues difficult to assess for outsiders, but also management discretion on the valuation of securities and the timing of impairments being recognized are other reasons that investors view trading revenues as opaque, hard to predict, and hard to compare. September 18, 2013 99 Canadian Bank Primer, Sixth Edition

Quarterly trading revenues have been noticeably more volatile for CIBC, followed by Bank of Montreal, as measured by the standard deviation of historical quarterly revenues compared to average quarterly revenue (Exhibit 81).

 Higher volatility of trading revenue could be explained by less diversified product areas or client bases, more concentrated proprietary positions, and/or weaker management or systems. We believe that more volatile trading revenue should be “worth” less because concerns about sustainability are higher.

Exhibit 81: Volatility in trading revenues has been higher at CIBC, followed by BMO

Trading Revenue Volatility (Calculation from Q1/00 to Q3/13) Quarterly Trading Revenue Average Median Standard Deviation ($ millions) (1) (2) (2) / (1) BMO $183 $166 $155 93% BNS $250 $224 $102 46% CM * $140 $164 $249 152% NA $100 $90 $42 47% RY $534 $481 $302 63% TD $297 $303 $154 51%

* CM excludes Q1–Q2/08. Including Q1–Q2/08, average-trading revenue would be $(2) million and standard deviation would be $622 million. Source: Company reports, RBC Capital Markets

Quarterly trading revenues have exhibited strong seasonality historically, with the first quarter of the year typically being by far the strongest of the year, with declines following in subsequent quarters. Four factors explain this in our view: (1) we believe that some bank customers look to manage the size of their balance sheets at year-end (December 31, which is during banks’ first quarter) and that other customers are looking to clean up their portfolios for reasons that can include tax planning ahead of year-end; (2) we believe that some bank customers establish positions in January (which is also part of banks’ first quarter) as part of year-ahead planning or strategy; (3) issuers with capital or funding needs tend to issue early in the year, in our view; and (4) the summer months tend to be quieter (which would explain weaker third and fourth quarters) (Exhibit 82).

We believe that spreads in fixed income and derivatives businesses could decline over time as more of that business becomes traded electronically, more moves to exchanges, and more is cleared centrally. We expect an offset from increased volumes but probably not enough to offset lower margins, and the keys to success in that business will likely shift from quality sales and trading individuals to quality information technology platforms (although this transition could progress for many years).

 The goal of the G20 in 2009 was to have all standardized over-the-counter derivative contracts on exchanges or electronic platforms and cleared through central counterparties by the end of 2012. The most recent progress report, published by the Financial Stability Board (FSB) in April 2013, outlined that currently less than half of the FSB member jurisdictions have legislative and regulatory frameworks in place to implement the G20 commitments, and there remains significant scope for increases in trade reporting, central clearing, and exchange and electronic platform trading in Global OTC derivative markets. Although the aggressive deadline was not met, the vast majority

September 18, 2013 100 Canadian Bank Primer, Sixth Edition

of FSB member jurisdictions are making progress towards adopting reforms that would achieve the G20 commitments, and the FSB expects that progress will accelerate over the course of 2013. Many derivatives contracts are customized and cannot be traded or cleared centrally, so margins on those products are likely to remain high, although capital requirements will likely rise. “Plain vanilla” derivatives will likely trade at narrower spreads once they are on exchanges and margins for investment dealers are likely to decline as a result, but capital requirements should also benefit.

ROE used to be higher for trading businesses than for lending businesses because tax rates and capital requirements were lower in trading businesses, although the gap is shrinking as new Basel 2.5 rules for market risk increased capital requirements starting in the first quarter of 2012, and counterparty credit risk charges will further increase capital requirements in Q1/14 as we discuss in “Section 8: Capital supports both expected and unexpected risks”. We believe that ROE for equity trading businesses will remain higher than for corporate lending, whereas ROE for fixed income businesses including derivatives will be close to ROE for corporate lending.

 The new capital requirements that are specific to wholesale markets (Basel 2.5 and the counterparty credit risk component of Basel III) affect trading businesses more than lending and underwriting businesses and, within trading, affect fixed income businesses more than equities and foreign exchange businesses. Areas of fixed income that, in our view, are particularly affected are structured products and the trading of non- investment grade securities. Proprietary trading and derivatives trading are seeing capital requirements increase much more than client-driven agency trading.

The best way to estimate ROE trends, in our view, is to compare trading revenues to Value at Risk (VaR).

 We believe that this methodology is particularly useful in tracking trends by bank.  Royal Bank and Scotiabank have historically been more efficient in generating trading revenue per unit of risk, while Bank of Montreal lags the group.  Differences in VaR calculations can account for some of the return differences, but we feel directionally confident in the risk measurement since the banks that generate the highest revenue per unit of VaR have also exhibited lower volatility in quarterly trading revenues (Exhibit 83).  Trading ROE, based on regulatory capital requirements, declined beginning in early 2012, which is when new market risk rules were put in place. Regulators realized that risk weightings for trading books were too low when the main driving metric (VaR) was calculated. The new rules are stricter because VaR calculations are more conservative, credit-sensitive positions in trading books attract higher capital charges, and securitization transactions are now be treated as if they were held in the banking book, therefore attracting more capital than if treated as trading positions.

September 18, 2013 101 Canadian Bank Primer, Sixth Edition

Exhibit 82: Trading revenues are typically stronger in Q1, followed by Q2

Reported Trading revenues Average Q1 Trading as % H1 Trading as % ($ millions) BMO BNS CM NA RY TD Total Q2/Q4 of Q2-Q4 Average of H2 2001 Q1 171 167 345 44 463 374 1,564 110% 108% Q2 179 139 260 55 471 362 1,466 Q3 124 187 226 52 417 432 1,438 1,423 Q4 131 144 236 83 401 369 1,364 2002 Q1 106 217 275 48 528 501 1,675 142% 119% Q2 67 203 109 44 422 304 1,149 Q3 112 180 112 42 455 218 1,119 1,177 Q4 106 176 117 45 488 330 1,262 2003 Q1 113 233 267 66 554 374 1,607 121% 120% Q2 141 206 220 66 481 334 1,448 Q3 139 194 164 86 525 204 1,312 1,332 Q4 115 169 127 122 457 246 1,236 2004 Q1 124 221 208 84 518 371 1,526 124% 129% Q2 140 187 243 63 473 305 1,411 Q3 125 166 139 52 417 264 1,163 1,231 Q4 83 188 135 65 440 209 1,120 2005 Q1 186 292 188 82 506 280 1,534 123% 118% Q2 151 222 147 75 412 319 1,326 Q3 151 213 314 106 376 202 1,362 1,249 Q4 183 207 171 96 321 80 1,058 2006 Q1 251 331 198 92 465 375 1,712 123% 124% Q2 200 259 171 83 586 251 1,550 Q3 195 187 152 66 537 242 1,379 1,395 Q4 104 254 164 113 447 174 1,256 2007 Q1 (299) 247 184 111 652 330 1,225 144% 217% Q2 36 256 123 115 544 289 1,363 Q3 80 312 (124) 90 515 308 1,181 852 Q4 (150) 154 (493) 121 160 219 11 2008 Q1 (249) 79 (3,327) 135 461 197 (2,704) n.m. n.m. Q2 176 218 (2,445) 72 (1) 101 (1,879) Q3 242 247 (868) 102 385 43 151 (697) Q4 574 61 (599) 78 (58) (418) (362) 2009 Q1 314 257 (617) 137 618 622 1,331 45% 53% Q2 209 331 (391) 190 1,447 412 2,198 Q3 436 514 353 169 1,602 633 3,707 2,964 Q4 282 378 361 197 1,210 560 2,988 2010 Q1 312 402 379 152 1,051 549 2,845 134% 144% Q2 430 419 225 150 957 402 2,583 Q3 166 293 131 920 148 300 1,958 2,117 Q4 276 307 86 139 620 383 1,811 2011 Q1 357 358 152 122 1,004 370 2,363 203% 241% Q2 308 280 146 131 602 303 1,770 Q3 202 234 (4) 87 259 113 891 1,162 Q4 45 224 22 85 167 283 826 2012 Q1 420 385 167 127 784 380 2,263 112% 107% Q2 334 384 172 126 761 278 2,055 Q3 271 429 122 132 660 360 1,974 2,024 Q4 439 389 116 159 625 316 2,044 2013 Q1 338 424 160 154 794 291 2,161 Q2 328 377 162 176 566 353 1,962 Q3 358 390 173 186 518 284 1,909 Median 123% 120% Source: Company reports, RBC Capital Markets

September 18, 2013 102 Canadian Bank Primer, Sixth Edition

Exhibit 83: Trading revenues have declined relative to risk, and they vary dramatically from bank to bank

Trading Revenue per unit of Risk*

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Median BMO 19x 25x 30x 48x (16)x 24x 53x 73x 59x 96x 50x BNS 89x 87x 123x 116x 78x 36x 87x 114x 81x 85x 86x CM 85x 99x 104x 73x (21)x (492)x (47)x 189x 58x 109x 65x NA 87x 54x 68x 61x 66x 38x 71x 87x 66x 95x 67x RY 155x 142x 135x 113x 89x 28x 92x 57x 48x 76x 83x TD 67x 105x 93x 105x 67x (2)x 57x 76x 52x 51x 62x Median 86x 93x 98x 89x 67x 26x 64x 82x 59x 90x 66x

* Annualized; Trading Revenue/Average Daily VaR. Source: Company reports, RBC Capital Markets

Trading revenues are normally, but not always, client driven Banks’ trading revenues can arise from corporate or government clients looking to mitigate risk, institutional fund managers, and hedge fund managers. There are several types of trades that the banks can execute for their clients. We summarize a few:

 Equity derivative trading: A client wants to hedge exposure to equity markets; for example, a life insurer looking to hedge guarantees dependent on equity market levels. A bank could use one or a combination of options, futures, swaps, or forward contracts to help the client meet its objective. The bank would then try to enter an offsetting position to mitigate risk.  Interest rate trading: A client looking to mitigate interest-rate volatility could use a bank. For example, a corporation with floating-rate debt may want to eliminate the risk of rising interest rates, which a bank could help with in many different ways (options, futures, swaps, or forward contracts). The bank would then look to a client seeking upside from potentially lower interest rates to offset its exposure, or it would enter an offsetting position with another dealer.  Credit trading: A client has an unsecured credit exposure to a purchaser but is worried about the credit quality of that purchaser (an auto-parts supplier could be an example). In this example, the client could purchase a credit-default swap from a bank that would hedge the credit risk in case of a default by the purchaser. Likewise, another client (a pension fund or insurance company, for example) may want credit exposure to that purchaser and may want to write a credit-default swap as a way to replicate the returns of a loan to that company.  Currency trading: A manufacturer sells a material portion of its production in a foreign country and does not want to run the risk of squeezed margins if its domestic currency strengthened (revenues would decline relative to costs). A bank could easily help that client mitigate its exposure and would ideally look for a company with a significant amount of costs that would benefit from a stronger domestic currency to offset its risk (i.e., a company with significant capital expenditures denominated in a foreign currency).  Commodity trading: A manufacturer needs to purchase a certain amount of raw materials yearly but does not want exposure to fluctuations in the cost of that raw material. Likewise, the seller of that raw material may want certainty over revenues and may also want to hedge its exposure to price fluctuations.

September 18, 2013 103 Canadian Bank Primer, Sixth Edition

Proprietary trading diversifies revenues but can introduce volatility With proprietary trading, banks look to employ their own capital to generate returns. We believe that many banks will continue to reduce their proprietary trading businesses given ongoing regulatory changes. Larger banks have the ability to diversify their trading strategies, so volatility is reduced. Banks that are overexposed to a few strategies are likely to experience higher volatility in revenues. There are many proprietary-trading strategies that are similar to many of the strategies employed by hedge funds. We summarize a few here:

 Arbitrage: Traders will take advantage of perceived mispricing between securities and/or indexes. For example, investors may try to take advantage of mispricing between loans, bonds, and credit-default swaps. Convertible traders try to take advantage of embedded options in convertible debt. Index arbitrageurs constantly monitor the value of an index and its underlying securities and will trade one against the other.  Equity long and short: Traders try to take advantage of expected valuation changes on both the long and short side, often employing leverage to magnify returns. Some traders try to maintain their exposure to be market neutral (be long as much as short) while some will take directional positions.  Event-driven: Traders try to take advantage of upcoming events such as potential mergers, recapitalizations, or distressed situations, often reaching out across asset classes (equities, bonds, loans, etc.). Leverage normally comes into the equation for announced M&A transactions.  Macro and global: Traders have latitude to do just about anything they want, across currencies, commodities, credit markets, and equity markets.  Sector: Traders will capitalize on their expertise in certain sectors and will trade only in that sector, usually both short and long, and usually employing leverage.

Trading accidents are most likely to come from proprietary positions, while client-driven revenues are driven by liquidity and capital markets activity. We believe that many banks worldwide have reduced and will continue to reduce their commitment to proprietary trading given ongoing regulatory changes and limits for US banks, what is likely to be increased cost of capital and funding for trading books, as well as a greater appreciation for downside risk following the events of 2007 until now. Banks that decide to remain in the proprietary trading field will likely have greater opportunities as a result of having less competition.

The Volcker rule will limit the size of some trading activities, with the effect on Canadian banks still unclear. The Volcker Rule is still being finalized, and it is expected to take effect in July 2014, although, once the rules are finalized, banks will be expected to, in good faith, plan to follow the new regulations. The rules will likely prohibit or limit some types of proprietary trading and investments in private equity funds or hedge funds for banks operating in the US. For trading businesses, the magnitude of the rule’s effect will depend on the definition of market making and the line drawn between market making and proprietary trading, since market making will be a permitted activity and could be broadly defined to disguise proprietary trading. For the US banks, these rules also apply to their foreign operations, and they might also apply to non-US banks with operations in the US. On equity and hedge fund investments, the banks are only allowed to own a maximum 3% of the interest of any fund. Also in aggregate, the total interest of a banking entity in all funds should not exceed more than 3% of Tier 1 capital. With respect to proprietary trading, there are some types of proprietary trading that will still be permissible, including trading treasuries, agencies, and munis, trading in connection with underwriting or market making, risk-mitigating hedging activities, and client order facilitation.

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 The effect on Canadian banks is still uncertain given limited disclosures and given that the rules are still not fully finalized. These rules, in our view, were not intended to apply to foreign banks’ foreign operations, but, based on the current wording of the draft, they might be affected. Banks, governments, and regulators in countries including Canada, certain European countries, and Japan have voiced their concerns over the extra-territorial reach of some of the rules and the potential adverse impacts of the Volcker Rule on the liquidity and valuation of non-US sovereign bonds. The potential impact on market-making operations are more meaningful, in our view, as the Canadian banks are not big in private equity and hedge funds and we believe that they do less proprietary trading than in the past.

VaR is the main risk-measurement metric for trading, but it has flaws The prior sections hopefully helped investors understand from where trading revenues come. This section deals with the main externally disclosed measure of risk for trading books, VaR, which we do not find that useful.

VaR is meant to estimate the maximum potentially adverse effect of market movements on the value of the banks’ trading portfolios in a day, with a certain confidence level (99% for Canadian banks), based on historical trading patterns. VaR is calculated for major risk categories: interest rates, credit spreads, exchange rates, equity, and commodity prices. The correlation between categories is also measured, and diversification benefits are taken into account.

We believe that VaR has many flaws, including the following:

 VaR assumes that recent historical price movements are a good indicator of potential future price movements. This assumption is misleading, particularly in times of low volatility. VaR methods also assume that securities are liquid, so it does not perform well when markets become illiquid because securities become difficult to value, or can lose value quickly and unexpectedly.  Trading losses should exceed stated VaR once every 100 days on average. Since tail events are what truly hurt banks (expected risks are normally “priced for”), we question the use of a risk measure, which by definition excludes larger risks. Stress testing would incorporate much more meaningful price drops than those assumed in VaRs in all asset classes.  VaR benefits from environments in which correlations are low. In times of crisis, correlations rise and market risk becomes higher than VaR would suggest.  No trader intervention is assumed.  VaR only measures the risk on proprietary positions and not the risk of lost revenues in a liquidity-challenged environment.  VaR is difficult to compare from bank to bank as models change over time in terms of inputs and also in terms of the length of historical data used.

As outsiders, we are not privy to the stress tests banks perform on their trading positions and securities portfolios, which in our view, are more relevant than VaR.26 Furthermore, market risk exposures can shift rapidly; for example, a bank may change the position of its balance sheet in a day to take advantage of expected moves in interest rates (which make

26 The banks have begun to disclose stressed VaR, which is a more punitive measure than traditional VaR methodologies, and inflated VaR by an average of 181%, ranging from 162% at Bank of Montreal to 233% at Royal Bank. September 18, 2013 105 Canadian Bank Primer, Sixth Edition

point-in-time disclosures, such as interest-rate gaps and sensitivity to fluctuations in interest rates, often outdated by the time the information is published).

Risk exposures, as measured by VaR, are minimal as a proportion of common equity (the industry median from 2001 to 2012 was 0.09%), although they have been poor predictors of tail risk (the 2007–2009 crisis was a good example). VaR had trended down for the industry before jumping up in 2007 because volatility and correlations increased, and then came down again (Exhibit 84).

A Basel consultative document on the fundamental review of the trading book published in May 2012 increased uncertainty regarding the capital requirements of the trading books once again. It is unclear what the incremental capital requirements would be at this stage, but the implication is higher, in our view, although there is no indication of the magnitude. Also, the proposal is subject to comment, so it could change. The aim is to strengthen the capital standards for market risk as the Basel 2.5 revisions did not fully address the shortcomings of the framework in the view of the Committee. There is a long list of proposed changes to the trading book capital regime. The main ones are a change in how the trading book could be defined (the boundary between the trading and banking book), the method of calculating market risk weighted assets (from Value at Risk to Expected Shortfall), and the requirement of calculating trading book capital under a standardized approach with the potential to limit the amount of relief allowed from an internal based model approach relative to this.

Exhibit 84: Market risk exposures increased in 2008 and 2009 but have declined since then

VaR (Average daily VaR) ($ millions) 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Median BMO 22.0 29.6 26.6 18.9 19.9 13.9 21.2 31.6 23.5 16.3 15.4 15.2 18.1 BNS 8.2 8.7 9.0 8.8 7.6 8.9 12.4 16.8 17.0 12.5 13.5 18.7 13.0 CM 14.2 12.9 9.2 7.3 7.9 9.4 14.6 14.7 6.3 4.4 6.5 4.9 7.2 NA 5.0 4.0 3.9 5.0 5.3 6.0 6.4 10.2 9.7 6.1 6.4 5.7 6.3 RY 11.0 11.0 13.0 13.0 12.0 18.0 21.0 28.0 52.8 48.0 42.0 37.0 32.5 TD 24.5 17.7 17.4 10.9 9.5 9.9 17.0 42.9 39.1 21.5 20.7 26.1 21.1 Median 12.6 12.0 11.1 9.9 8.7 9.7 15.8 22.4 20.3 14.4 14.4 17.0 15.6

VaR as % of Common Equity 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Median BMO 0.25% 0.33% 0.27% 0.18% 0.16% 0.10% 0.15% 0.20% 0.13% 0.08% 0.07% 0.06% 0.11% BNS 0.07% 0.07% 0.07% 0.06% 0.05% 0.05% 0.07% 0.09% 0.08% 0.05% 0.05% 0.05% 0.05% CM 0.15% 0.16% 0.10% 0.08% 0.11% 0.09% 0.13% 0.13% 0.06% 0.03% 0.05% 0.03% 0.08% NA 0.15% 0.14% 0.13% 0.16% 0.15% 0.14% 0.15% 0.22% 0.18% 0.10% 0.11% 0.09% 0.14% RY 0.09% 0.08% 0.08% 0.08% 0.08% 0.09% 0.09% 0.10% 0.16% 0.14% 0.12% 0.09% 0.10% TD 0.27% 0.21% 0.18% 0.10% 0.09% 0.05% 0.08% 0.14% 0.11% 0.06% 0.05% 0.06% 0.07% Median 0.15% 0.15% 0.11% 0.09% 0.10% 0.09% 0.11% 0.14% 0.12% 0.07% 0.06% 0.06% 0.09% VaR as % of Tier 1 Capital 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Median BMO 0.20% 0.26% 0.22% 0.14% 0.13% 0.08% 0.12% 0.17% 0.11% 0.08% 0.06% 0.06% 0.10% BNS 0.05% 0.05% 0.05% 0.05% 0.04% 0.04% 0.06% 0.07% 0.07% 0.05% 0.05% 0.05% 0.05% CM 0.12% 0.12% 0.07% 0.06% 0.08% 0.08% 0.12% 0.12% 0.04% 0.03% 0.04% 0.03% 0.06% NA 0.12% 0.11% 0.10% 0.13% 0.12% 0.13% 0.14% 0.19% 0.15% 0.09% 0.09% 0.08% 0.12% RY 0.07% 0.07% 0.08% 0.08% 0.06% 0.08% 0.09% 0.11% 0.17% 0.14% 0.12% 0.10% 0.11% TD 0.23% 0.18% 0.15% 0.09% 0.07% 0.06% 0.11% 0.21% 0.18% 0.09% 0.07% 0.08% 0.09% Median 0.12% 0.11% 0.09% 0.08% 0.08% 0.08% 0.11% 0.14% 0.13% 0.08% 0.07% 0.07% 0.09%

Source: Company reports, RBC Capital Markets

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Corporate lending ROEs have improved Of the three main wholesale business lines, corporate lending has historically been the least profitable, in our view, although the gap with trading has shrunk. Business lending has historically been viewed as a low-ROE business that was necessary if a bank wished to have high-ROE ancillary business such as equity and debt underwritings as well as M&A assignments. As detailed earlier, higher regulatory capital requirements are pressuring the profitability of trading operations, while Basel II capital changes and improved spreads have improved the returns of banks’ corporate lending businesses in the last five years, and loan losses remained fairly low in the last credit cycle. We believe that ROE for equity trading businesses will remain higher than for corporate lending, whereas ROE for fixed income businesses including derivatives will be close to ROE for corporate lending. Business lending contributes anywhere from 10% to 40% of wholesale revenues in normal years.

Annual growth in business lending has been more volatile than in retail lending (typically following business investment cycles) and has averaged 6% since 1980, peaking at 16% in 2007 and troughed at -17% in January 2010. Indicators that we find useful to predict growth include business expenditure and industrial production. The most recent year-over-year growth rate in business lending was 12% (12 months ended July 2013). (Exhibit 85)

 We expect growth in business lending to slow from high levels as the business investment cycle (which is highly correlated to business loan growth) has slowed down. Historical growth in business lending has been more volatile than in retail lending, and it was negative in this past recession, as was the case in the recessions of the early 1980s, 1990s, and 2000s. Growth recovered sharply as the business investment cycle (which is highly correlated to business loan growth) improved, and we expect loan growth to remain positive until the business investment cycle turns.  Compared to the last business investment cycle, we believe Canadian banks have gained share from banks with less strong balance sheets (Exhibit 86), and we also believe that off-balance sheet conduits that would have been indirect providers of credit to business “pre-crisis” have become much smaller. We believe this is part of the reason that Canadian bank business loan growth troughed slightly ahead of the industry. Business loan balances for Canadian banks troughed in H1/10 and total bank balance growth has improved since then to about 12% (Exhibit 85).  The other difference with prior cycles (which is negative) is that businesses might look to lock in low financing costs for an extended period and, as such, might be more willing to issue debt than take out shorter-term bank loans. This is an opportunity available for larger businesses but not for mid-market and smaller commercial clients. While at the margin a negative for growth in Canadian banks’ loan books, it would be positive for their debt underwriting revenues. Larger companies are well capitalized, and many have issued debt rather than taken out bank loans.

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Exhibit 85: Business expenditure and Industrial production are useful indicators of business credit growth

Canadian Business Credit vs. Business Expenditure Canadian Business Credit vs. Industrial Production (Since 1983) (Since 1982) *Correlation Coefficient: 0.75 Correlation Coefficient: 0.47 40% 20% 20%

15% 15% 30%

10% 10%

20% 5% 5%

10% 0% 0%

-5% -5% 0%

-10% -10%

-10% -15% -15%

-20% -20% -20% 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Business Credit YoY Growth Business Expenditure YoY Growth Business Credit YoY Growth, 9-month lagged (LHS) Canadian Industrial Production YoY Change (RHS) *Business credit growth lagged one year for correlation

Source: Company reports, RBC Capital Markets

Exhibit 86: Big Six banks have gained business lending share since 2008

Chartered banks Big Six Bank Share Business loans C$ 2008 2010 Jun-13 2008 2010 Jun-13 BMO 6.9% 9.0% 8.7% BNS 5.1% 5.7% 5.7%

Source: Bank of Canada, OSFI, Company reports, RBC Capital Markets

Until mid-2007, Canadian banks had generally managed down their exposures to corporate lending relative to their retail exposure (business loans declined to 35% from 70% of loans in 1983) because:

 Banks were happy to manage down exposures given the beneficial effect on ROE (low spreads and high-capital requirements made for low ROE in corporate lending), especially in instances where corporate relationships were not impaired as a result.  There was high demand for loans from third parties, such as conduits of collateralized- loan obligations, hedge funds, and pension funds.  The pricing on such loans had been extremely competitive because risk spreads on corporate debt were very tight. Since secondary markets have become increasingly liquid, the pricing of loans, bonds, and credit-default swaps all converged at the expense of loan spreads.  Companies wishing to raise debt could go directly to the market if bank loans were not available at conditions that were desirable to those companies.

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Disclosure makes it difficult to measure spreads earned by the banks on their corporate loan books, but they should directionally move in line with the spread between corporate bond spreads and banks’ wholesale funding rates. We believe that spreads have improved in the last five years. Loan pricing has become more in line with publicly traded securities of similar risk because liquidity in debt markets improved, and issuers took advantage of that liquidity and of low rates by raising debt rather than looking to banks for their capital needs in the last decade. Given the tightness of corporate and high-yield bond spreads until the dislocations of mid-2007, loan spreads declined until then. Bond spreads have increased from the summer of 2007, which has given the banks greater pricing power on new loans, although a portion of the increased yield on assets has been offset by higher wholesale funding rates for banks. (Exhibit 87)

Exhibit 87: Corporate bond spread and corporate loan pricing trends are similar

Canadian corporate BBB spread vs. 5yr senior debt spread

500

400

300

Spread(bps) 200

100

(100) Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

Spread CDN Corp BBB 5yr Spread CDN Bank 5yr Senior Debt Spread

Source: Bloomberg, RBC Capital Markets

Basel II capital rules improved ROE for lower-risk corporate loans.

 Under Basel I regulatory capital requirements, all corporate loans had risk weights of 100%. A high-quality loan yielding a spread of 50 basis points would have generated a ROE of just more than 4% if a bank allocated 8% of common equity to risk-weighted assets, which of course assumes zero credit losses and expenses (because it is a marginal-loan analysis), but it also excludes ancillary fees.  Under Basel II regulatory capital requirements (no changes under Basel III), risk weightings for corporate loans vary from 20% to 150% for banks operating under the standardized approach (and less for the Big Five Canadian Banks, which operate under the advanced method). A high-quality loan with a spread of 50 basis points and a risk weighting of 50% would now generate a return of just over 8% using the same common equity allocation of 8% (again, before expenses, losses, or ancillary fees).

Loan losses have historically been volatile, and in years of high losses, banks with high concentrations in industries or issuers facing difficulties had the highest losses (Exhibit 131). Banks aim to diversify their loan portfolios across countries and industries to mitigate

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risk. Limits are initially established by industry, and banks also have single-name limits for individual issuers, which vary depending on the issuer’s rating (banks will have lower-lending limits for riskier customers). Limits can be managed as follows:

 At the time of issue, a bank advances funds to a customer only up to its internal limit.  If a customer needs more funds, a bank may loan the money but then syndicate a portion of that loan or purchase a credit-default swap against a portion of the loan.

We discuss credit risk for business lending in detail in “Section 7: Loan losses can be material”, but we note that corporate credit issues were less of an issue in the last cycle and that exposure has declined. In a nutshell, we believe that business provisions for credit losses will remain low in the next 12 months. The credit indicators that we look at are pointing toward low losses including credit spreads, rating agency downgrades, upgrades, tightening, easing underwriting standards, and employment growth (Exhibit 125, Exhibit 126, and Exhibit 127). Derivatives both reduce and increase risk for banks Derivatives have garnered a lot of attention in the 2007 – 2009 period as the plight of financial guarantors and the failure of Lehman Brothers (and near failure of many others) highlighted the counterparty risk prevalent in derivatives contracts, and as the volatility in credit markets showed how rapidly exposures can grow given the leverage embedded in derivatives.

Banks have exposure to derivatives on their balance sheets for different purposes: 1) they may hedge balance sheet positions, interest rate exposures, and/or currency exposures; 2) they may be acting as intermediaries for clients; and 3) they may use derivatives as part of their proprietary trading strategies. Derivative books are generally matched on a long-short basis, unless they are being used to hedge balance sheet positions or other exposures. The notional principal outstanding for the six banks as of the second quarter of 2013 was $19 trillion (Exhibit 88). Derivative exposures net of netting and collateral are much smaller than notional exposures.

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Exhibit 88: Derivative exposures net of netting and collateral much smaller than notional

Derivative Exposure 2011 2012 2013 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

Notional Principal ($ Billions) BMO $2,929 $3,217 $3,320 $3,512 $3,127 $3,246 $3,470 $3,348 $3,128 $3,415 $3,473 BNS $2,236 $2,596 $2,708 $2,542 $2,530 $2,742 $2,709 $2,766 $2,911 $2,792 $3,098 CM $1,411 $1,522 $1,679 $1,594 $1,577 $1,633 $1,742 $1,784 $1,782 $1,842 $1,928 NA $479 $599 $627 $542 $543 $586 $597 $555 $535 $523 $503 RY $6,297 $6,526 $6,765 $6,928 $6,521 $6,291 $6,567 $6,597 $7,025 $6,954 $7,428 TD $2,925 $3,183 $3,393 $3,263 $3,359 $3,576 $3,772 $3,791 $3,856 $4,066 $4,252 Total $16,278 $17,643 $18,491 $18,382 $17,657 $18,073 $18,855 $18,842 $19,236 $19,592 $20,682

Notional Principal as multiple of Common Equity BMO 164x 180x 147x 150x 129x 133x 136x 128x 117x 126x 127x BNS 100x 105x 106x 96x 90x 90x 84x 78x 79x 73x 79x CM 119x 125x 132x 121x 114x 114x 117x 118x 116x 118x 120x NA 86x 107x 109x 94x 90x 91x 90x 86x 80x 75x 69x RY 199x 203x 202x 199x 179x 172x 171x 167x 173x 168x 174x TD 85x 93x 94x 83x 83x 87x 87x 86x 86x 88x 92x Median 110x 116x 121x 109x 102x 103x 104x 102x 101x 103x 106x

Credit Risk Equivalent Amount after Netting ($ Billions) BMO $24 $26 $27 $27 $24 $23 $22 $21 $20 $21 $20 BNS $21 $22 $21 $22 $21 $21 $21 $20 $31 $30 $31 CM $11 $12 $13 $12 $13 $13 $12 $11 $13 $13 $14 NA $7 $8 $8 $6 $7 $6 $7 $7 $7 $8 $8 RY $46 $48 $49 $50 $47 $42 $41 $33 $55 $54 $54 TD $29 $34 $35 $35 $39 $36 $41 $35 $33 $34 $27 Total $139 $150 $152 $152 $150 $141 $144 $127 $160 $160 $154

Credit Risk Equivalent after Netting as % of Common Equity BMO 135% 145% 121% 116% 97% 92% 86% 80% 76% 78% 72% BNS 92% 87% 81% 85% 76% 69% 64% 56% 84% 79% 80% CM 94% 100% 99% 92% 91% 89% 83% 72% 85% 84% 87% NA 131% 147% 143% 101% 109% 101% 98% 104% 110% 117% 114% RY 146% 149% 145% 143% 128% 115% 108% 85% 135% 130% 127% TD 85% 100% 97% 88% 97% 88% 96% 79% 74% 74% 59% Median 112% 122% 110% 96% 97% 90% 91% 80% 85% 82% 83%

Source: OSFI, Company reports, RBC Capital Markets

A derivative is a contract between two parties, which requires little or no initial investment and where payments between the parties are dependent on the movements in price of an underlying instrument, index, or financial rate. Examples of derivatives include swaps, options, forward-rate agreements, and futures.

 The notional amount of the derivative is the contract amount used as a reference point to calculate the payments to be exchanged between the two parties, and the notional amount itself is generally not exchanged by the parties. The notional amounts involved with derivatives are very large, representing large multiples of equity (Exhibit 88). Banks are exposed to the moves in the value of the assets to which derivatives refer. For example, a $100-million currency swap will “cost” $10 million to a bank on the wrong side of a trade if there is a 10% move in the value of the currency.  We believe that credit derivatives are potentially more volatile than other types of derivatives because the value of the underlying assets can go to zero, an unlikely outcome for other types of derivatives. Credit derivatives grew rapidly in the decade prior to 2007, with growth reversing since then. Scotiabank and National Bank have the most exposure to credit derivatives relative to their common equity and TD Bank the least, based on credit equivalent amounts relative to equity (Exhibit 89).

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Exhibit 89: Exposure to credit derivatives probably warrants the closest attention

Credit Derivative Exposure (as at Q3/13, in $ billions) Notional Replacement Credit Equivalent Net CEA Risk Weighted Principal Cost Amount (CEA) % Equity Balance BMO $23.7 $0.2 $0.5 1.8% $0.4 BNS $74.3 $0.6 $3.1 8.0% $0.6 CM $20.6 $0.3 $0.2 1.1% $0.1 NA $1.2 $0.1 $0.4 5.7% $0.1 RY $12.2 $0.1 $0.8 1.9% $0.4 TD $11.3 $0.0 $0.4 0.9% $0.2 Total $143.2 $1.4 $5.4 3.0% $0.4

All values are net of netting; CEA = Credit Equivalent Amount. Source: Company reports, OSFI, RBC Capital Markets

Exhibit 90: After rapid growth in 2004 to 2008, credit derivatives have generally declined

Credit Default Swaps 70

50 US$, trillions US$, 40

Source: BIS Quarterly Review, June 2013, International Swaps and Derivatives Association Inc., RBC Capital Markets

Derivatives are initially recorded at fair value on the balance sheet (as an asset if the fair value is positive and as a liability if negative, recognizing netting agreements where both sides have a legal right and intent to settle simultaneously). Thereafter, recognition of fair- value changes depend on whether a derivative is held for trading (mark-to-market accounting) or used for hedging the bank’s exposures (hedge accounting allows a bank to offset gains and losses between the derivative and the underlying instrument).

Measures of credit risk related to derivative transactions include replacement cost (the fair value of outstanding contracts in a positive or gain position; in other words, how much a bank is owed by counterparties on trades on which the bank is “in the money”) or its credit equivalent amount (defined as the sum of the replacement cost and an additional amount

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for potential future credit exposure that is defined by OSFI to account for potential volatility in the value of derivatives exposures). Exhibit 91 shows that the banks’ credit equivalent amounts as a percentage of common equity rose from 2000 to 2007 and have come down quite significantly since 2007.

Exhibit 91: Credit equivalent exposure to derivatives rose until 2007 but has declined since

Derivatives - Credit Equivalent Amount as % of Common Equity (Since 1996)

230%

210%

190%

170%

150%

130%

110%

90%

70% 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 Q3/13

Average Big Six Banks. Source: Company reports, OSFI, RBC Capital Markets

Derivatives can be a powerful risk-management tool, allowing banks and/or their clients to eliminate or mitigate a myriad of risks rapidly. Potential examples abound, but a commodity producer can hedge the price of its expected production for years, thereby greatly reducing revenue volatility; the same can be done for companies with a currency mismatch between revenues and expenses. Banks acting as intermediaries benefit from matching buyers and sellers. Banks also use derivatives to hedge many risks themselves, including credit risk (they may buy credit-default swaps on outsized lending exposures), interest rate risk (a bank may convert fixed-rate assets into floating-rate assets or vice versa to better match the duration of its funding liabilities), or currency risk arising from having operations in different geographies.

Derivatives can also introduce risk, however. Derivatives can allow speculators to create large notional exposures with very little capital. An incorrect bet may lead to that speculator being out of the money and unable to “make good” on his or her promise to the other side of the derivative contract.

Exposure to derivatives is a point-in-time measure, and volatility in fair value of hedges should be expected. Because of the leverage that accompanies derivatives, fair value can move quickly, particularly if the underlying assets are volatile. For example, the fair value of CIBC’s hedges related to collateralized debt obligations (CDO) of sub-prime residential mortgage-backed securities (RMBS) grew to $4.7 billion as of December 31, 2007, from $1.3 billion as of October 31, 2007. The same could happen to derivatives that refer to assets that are of lower risk; because notional values are so high, fairly small movements in the price of the underlying assets can have a large effect on the fair value of derivatives.

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 The mark-to-market accounting treatment of derivatives introduces volatility to income statements and balance sheets. For derivatives used for proprietary and client- trading activities, realized and unrealized gains and losses are recognized in non-interest income. Derivatives are reported as an asset if the fair value is positive and as a liability if negative, with netting agreements recognized where both sides have a legal right and intent to settle derivative transactions simultaneously. A bank can use hedge accounting for derivatives used to manage its own exposures. Hedge accounting essentially allows a bank to offset gains and losses between the derivatives and the underlying assets or liabilities, which reduce income statement fluctuations that are due to changes in interest rates, or foreign exchange changes can be hedged.

Disclosures are adequate enough to help outsiders determine growth in derivatives positions, which is directionally helpful because rapid growth in derivatives positions can be a red flag, as is the case for many financial products. In traditional loan books, for example, rapid growth in a loan category is often followed by a hangover from a credit perspective. Worldwide, derivatives balances grew tremendously fast until 2007, with credit derivatives leading the way. An outsider can only conclude that a bank with more exposure to derivatives probably has more operational, market, and credit risk than has historically been reflected in capital ratios or VaR disclosures. Unfortunately, the word “probably” is the key to that last sentence, and the degree of additional risk is not possible to determine, in our view, because disclosure on assets to which derivatives refer is poor.

Counterparty risk is ultimately the biggest risk for players that act as market makers in derivatives (those that take directional bets, as opposed to acting as intermediaries, have different risks). A bank with similar long- and short-derivative positions will, by definition, be owed money by a counterparty as the underlying assets witness price movements. Key mitigants are diversification, collateral agreements, and quality of counterparties. The disclosures available are not consistent from bank to bank. Counterparty credit risk was underestimated in the past, and new regulatory capital rules will be introduced for Canadian banks in the first quarter of 2014.

 The failure of a counterparty would have a meaningful implication for banks, but a key risk mitigant for banks is the presence of collateral agreements. Banks generally look to run their derivatives on a roughly matched basis (i.e., they will be long and short derivatives in similar amounts). If a counterparty failed, banks’ losses up to that day would be mitigated by collateral postings (assuming that that counterparty was out of the money on some positions with the bank being analyzed). The counterparty’s failure, however, all of a sudden would leave banks exposed to future price movements on derivatives that would then be unhedged, and they would then have to find new counterparties to “rehedge” their exposures. Since the failure of a large counterparty would likely happen when asset prices are volatile, the risk of trading losses would rise (as would capital requirements for trading books). We believe that the process of “rehedging” exposures to interest rate and currency hedges would be easiest, and “rehedging” credit default-swap exposures would likely be more difficult.  Banks have lower collateral requirements with well rated counterparties, a technique that makes sense but proved imperfect when financial guarantors ran into financial difficulties in 2007–2009 (most were AAA-rated before that period and did not post collateral when writing credit-default swaps).  Collateral requirements increased following the 2007–2009 period. Losses that occurred from trading with firms that once were well rated led to the industry’s tightening the management of counterparty credit risk. We believe that the largest dealers operate on close to a fully collateralized basis (subject to credit limits) whereas trading with governments or corporate customers is not always fully collateralized. September 18, 2013 114 Canadian Bank Primer, Sixth Edition

 Counterparty credit risk is difficult to measure as there are three factors at play, and not all are easy to measure. First, how much is a bank owed by a counterparty, which is a function of the underlying assets being traded. That exposure is easy to measure. Secondly, what is the credit worthiness of the counterparty that owes the bank, how much collateral has been posted, and what is the quality of that collateral. This exposure is also relatively simple to measure. The third exposure is more difficult to measure: how much might a bank find itself owed by a counterparty based on fluctuations in the value of the underlying asset being traded. That is more difficult to measure as it is based on historical price movements and confidence levels, which, as we explained in the earlier trading section when discussing VaR, is far from being a perfect method.  There is also an additional risk element that is market risk-like but would arise if a counterparty failed—so arguably, the root of the risk is credit risk: if a counterparty failed, as we explained above, the bank would find itself exposed to future price movements on derivatives that would all of a sudden be unhedged, and the bank would then have to find new counterparties to “rehedge” its exposures. Since the failure of a large counterparty would likely happen when asset prices are volatile, the risk of trading losses would rise (as would capital requirements for trading books).  New rules for counterparty credit risk will be introduced in the first quarter of 2014 for Canadian banks. It will become more capital intensive to trade derivatives, particularly where derivatives have potential volatile underlying assets, longer duration, and counterparties are of weaker quality. Banks have disclosed the potential impact of the additional charge to capital in 2014, which ranges from ~20 basis points at CIBC to ~10 basis points at National Bank. We expect that the probable move to central clearing facilities for derivatives in many jurisdictions will reduce capital charges relative to the potential impacts disclosed by the banks (although it will also likely reduce margins on some of the derivative transactions). For more details on the potential changes, please see “Section 8: Capital supports both expected and unexpected risks”.

The goal of the G20 in 2009 was to have all standardized over-the-counter derivative contracts on exchanges or electronic platforms and cleared through central counterparties by the end of 2012. The most recent progress report, published by the Financial Stability Board (FSB) in April 2013, outlined that currently less than half of the FSB member jurisdictions have legislative and regulatory frameworks in place to implement the G20 commitments, and there remains significant scope for increases in trade reporting, central clearing, and exchange and electronic platform trading in Global OTC derivative markets. Although the aggressive deadline was not met, the vast majority of FSB member jurisdictions are making progress towards adopting reforms that would achieve the G20 commitments, and the FSB expects that progress will accelerate over the course of 2013. Clearly, many derivatives contracts are customized and cannot be traded or cleared centrally, so margins on those products are likely to remain high and capital requirements will likely rise. “Plain vanilla” derivatives will likely trade at narrower spreads once they are on exchanges and margins for investment dealers are likely to decline as a result, but capital requirements should also benefit. Securities accounting and understanding disclosures In this section, we discuss the accounting for securities, how to directionally forecast writedowns, and the challenges associated with those forecasts.

Securities: Understanding the accounting Accounting for securities depends on whether they are classified as trading securities (fair value through profit or loss) or available-for-sale (AFS) securities. Trading securities make September 18, 2013 115 Canadian Bank Primer, Sixth Edition

up 68% of total securities at the Big Six Banks, while AFS securities make up 32%. The banks no longer hold held-to-maturity (HTM) securities.27 The mix of securities has changed since we published our first primer in October 2008 with trading securities then representing 75% of securities and AFS at just less than 25%.

Trading securities (fair value through profit or loss) are liquid securities, generally debt or equity, that are bought and sold in the near term. They are measured at fair value with changes recognized in non-interest income, and interest and dividends affecting interest income (or interest expense if a trading liability). Fair value is based on quoted prices in an active market, or can be determined using valuation models with quoted prices of similar securities and observable market inputs that are not subject to judgment.

 The changes in market value of trading securities affect income (and, by default, equity). AFS securities do not affect the income statement unless there is a permanent impairment in value. For example, they can be equity investments in a merchant-banking portfolio, or treasury derivatives bought and sold for liquidity needs or to hedge interest rate or foreign currency risk. They are measured at fair value each quarter, with changes recognized in Other Comprehensive Income (OCI)28, except for securities such as equity investments that do not have quoted market prices, in which case they are recorded at cost and written down when there is a permanent impairment. Other writedowns are assessed each quarter if management decides that the impairment is permanent, which hits the income statement.

 The changes in market value of AFS securities, therefore, affect shareholders’ equity, but not income unless the changes in value are deemed to be permanent.  Under Basel III, accumulated other comprehensive income (AOCI) is added or deducted, depending on the balance to common equity Tier 1 capital. This regulatory treatment differs from Basel II, as under Basel II Tier 1 common capital was only impacted by unrealized losses on equity AFS securities was not impacted by unrealized gains or losses on AFS debt securities.  Tier 1 and Total capital calculations are also affected by unrealized gains or losses on AFS securities, through movements in AOCI.

The concept of fair value securities is one that has evolved. In a perfect world, securities would all be actively traded, quoted prices would be readily available, and banks could use the market quotes to value their assets. The reality, however, is that quotes from public markets are not always available, and as has been exemplified in the 2007–2009 period, trading activity in illiquid markets can lead to rapid shifts in the value of securities, whether securities are impaired or not.

When market quotes for financial instruments are unavailable, fair value is determined subjectively. Accounting standards require credit risk to be reflected in the fair value of these instruments, as financial instruments with quoted market prices reflect the credit quality of the counterparty. Credit valuation adjustments (CVA) reflect changes in a counterparty’s credit spreads on the fair value of financial assets. Debt valuation adjustments (DVA) reflect changes in a company’s own credit spreads on the fair value of liabilities. Collateral and master netting agreements are considered when assessing DVA/CVA on OTC derivatives.

27 On adopting IFRS in 2012, banks had to classify or designate financial instruments as fair value through profit or loss, or as an available-for-sale security (under International Accounting Standard, IAS 39). 28 OCI does not affect earnings, but rather, it affects shareholders’ equity in a given reporting period. Accumulated OCI (AOCI) is the accumulated balance including prior periods that is shown in the shareholders’ equity section of the balance sheet. September 18, 2013 116 Canadian Bank Primer, Sixth Edition

The accounting profession judged in late 2008 that market quotes were not always reflective of fair market value and that banks can now use judgement in valuing securities in instances where the market prices of securities that are not impaired reflect distressed sales or large liquidity premiums.

 The advantages of using market quotes are obvious: transparency and consistency between banks; however, there can be instances where the market quotes do not reflect an active market. For example, if demand for a certain type of product vanishes but a holder is forced to sell, the discount to theoretical value based on expected cash flows is likely to be heavy. Is that trade value reflective of a fair market value?  The advantage of model-based methodologies is that market-driven factors that might lead to unreliable quotes no longer affect the value of securities books, which has positive implications for earnings and capital volatility. However, there are two significant disadvantages to model-based methodologies: 1) they reduce the consistency of valuation approaches between banks and introduces comparability challenges; and 2) if capital market participants mistrust management teams’ ability to assess fair value fairly, then that could have negative implications for valuation multiples.

Exhibit 92: TD and BMO have the largest exposure to AFS securities as a % of CET1

Available-for-Sale Trading Total 2011 2012 Q3/13 2011 2012 Q3/13 2011 2012 2007 (C$ millions) IFRS IFRS IFRS IFRS IFRS IFRS IFRS IFRS IFRS BMO 51,426 56,382 50,679 69,925 70,109 72,491 121,351 126,491 128,016 % of Common Equity 219% 215% 185% 298% 268% 265% 517% 483% 468% % of Common Equity Tier 1* 256% 261% 246% 349% 325% 351% 605% 586% 621% % of Tier 1 Capital 205% 218% 211% 279% 271% 302% 484% 488% 534% BNS 28,980 33,171 35,036 62,192 74,639 91,829 91,172 107,810 126,865 % of Common Equity 110% 94% 90% 236% 212% 235% 346% 306% 324% % of Common Equity Tier 1* 137% 119% 139% 293% 268% 365% 430% 386% 504% % of Tier 1 Capital 102% 96% 113% 218% 217% 296% 320% 313% 409% CM 27,118 24,700 24,915 33,177 40,330 42,886 60,295 65,030 67,801 % of Common Equity 206% 163% 155% 252% 266% 267% 458% 429% 423% % of Common Equity Tier 1* 229% 197% 200% 280% 321% 344% 509% 518% 543% % of Tier 1 Capital 167% 155% 143% 205% 253% 246% 372% 408% 389% NA 9,142 10,374 10,506 47,450 44,520 44,409 56,592 54,894 54,915 % of Common Equity 158% 161% 143% 820% 689% 606% 978% 850% 749% % of Common Equity Tier 1* 179% 209% 201% 927% 895% 848% 1106% 1104% 1049% % of Tier 1 Capital 133% 155% 151% 692% 663% 637% 826% 818% 788% RY 38,894 40,828 36,818 128,128 120,783 137,484 167,022 161,611 174,302 % of Common Equity 111% 103% 86% 367% 306% 323% 479% 410% 409% % of Common Equity Tier 1* 137% 139% 127% 452% 411% 473% 590% 549% 600% % of Tier 1 Capital 109% 111% 92% 359% 328% 342% 468% 439% 434% TD 93,520 98,576 90,315 77,589 94,531 96,794 171,109 193,107 187,109 % of Common Equity 239% 223% 196% 198% 214% 210% 437% 438% 407% % of Common Equity Tier 1* 437% 413% 356% 363% 396% 382% 799% 808% 738% % of Tier 1 Capital 328% 318% 291% 272% 305% 311% 600% 623% 602% Total 249,080 264,031 248,269 418,461 444,912 485,893 667,541 708,943 739,008 % of Common Equity 174% 158% 139% 293% 267% 272% 467% 425% 414% % of Common Equity Tier 1* 231% 219% 211% 388% 370% 412% 618% 589% 627% % of Tier 1 Capital 177% 175% 165% 297% 295% 323% 474% 470% 491%

* Common equity Tier 1 prior to Q1/13 represents Tier 1 common capital under Basel II. Source: Company reports, RBC Capital Markets

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Using disclosures to better understand securities portfolios Securities and derivatives exposures are notoriously opaque, making it difficult for outsiders to understand their composition and risk profile. In this section, we detail:

 What investors might learn from using fair value disclosures, which provide an indication of banks’ exposure to illiquid securities.  How movements in other comprehensive income provide clues as to potential future writedowns.  What leading indicators provide clues as to the directions of writedowns and/or increases in unrealized losses on available for sale assets.

Changes in values of AFS securities matter for regulatory capital Pressure on fair values of securities from 2007 to 2009 resulted in a higher level of unrealized losses in the banks’ AFS portfolios than would be the case in more benign credit (and equity) markets. Since 2009, the continued gradual decline in medium/long-term interest rates has had the opposite effect and has led to large unrealized gains at banks with larger, and longer duration AFS-debt securities portfolios. The changes in values of AFS-securities portfolios have an effect on banks’ common equity Tier 1 ratios, as accumulated other comprehensive income (AOCI) is included in common equity Tier 1 capital29. For example, TD Bank has a large positive accumulated other comprehensive income balance, largely due to net unrealized gains on fixed income securities in its AFS portfolio in the US. If rates were to rise rapidly, this balance has the potential to swing the opposite direction. Recently, TD Bank has been actively crystallizing gains in this portfolio and reducing the duration to eliminate the future potential volatility to its common equity Tier 1 ratio as rates continue to increase.

Canadian banks’ AFS securities portfolios are largely made up of government and corporate debt securities. Although a bank may have a larger unrealized gain/loss in one quarter, it doesn’t necessarily mean that its common equity Tier 1 ratio is more exposed to volatility as it is hard to predict the movement in fair values of a banks securities portfolio without further detail around asset composition, size, credit quality, and duration.

For unrealized losses on AFS securities to affect earnings, bank management teams have to deem valuation declines as permanent, which is an assessment done each quarter. We believe there are two primary factors that would influence that view:

 The length at which assets trade below their book value, which forces management to question its valuation assumptions. Unrealized losses are deemed temporary when management can argue that a liquidity discount is the primary reason that there can be gaps between current market prices of securities and the expected realization of value closer to the maturity of the assets. We believe that, when asset prices are below accounting values for an extended period, management is more likely to deem some of the valuation declines as permanent.  A change in the underlying credit quality, which would impair cash flows. Important metrics to track for CDOs of corporate debt, collateralized loan obligations (CLO), and asset-backed commercial paper (ABCP) with CDOs of corporate debt are corporate defaults. An increase in corporate defaults would reduce subordination in those structures and might cause management teams to question their assumptions. For

29 In contrast to Basel II were Tier 1 common capital was only impacted by unrealized losses on equity AFS securities was not impacted by unrealized gains or losses on AFS debt securities. September 18, 2013 118 Canadian Bank Primer, Sixth Edition

RMBS and commercial mortgage-backed securities (CMBS), default rates and real estate prices are the two most important factors to follow.

While we accept the fact that many unrealized losses on AFS securities are temporary in nature and can be offset by unrealized gains, banks with greater unrealized loss balances on AFS securities, for longer periods of time, are more at risk of having writedowns that affect earnings, all else being equal.

September 18, 2013 119 Canadian Bank Primer, Sixth Edition

Exhibit 93: In general, unrealized gains and unrealized losses were mixed in 2012;TD and National have the highest exposures as a % of common equity

Unrealized gains and losses on available-for-sale securities (C$ millions) 2012 BMO BNS CM NA RY TD Gross Gross Gross Gross Gross Gross Gross Gross Gross Gross Gross Gross Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Gains Losses Net Gains Losses Net Gains Losses Net Gains Losses Net Gains Losses Net Gains Losses Net Available-for-sale (AFS) securities Securities issued of guaranteed by: Canadian Federal Government 265 (38) 227 127 (1) 126 84 (2) 82 56 - 56 513 - 513 38 (1) 37 Canadian Other Governments 39 (1) 38 39 - 39 28 (2) 26 274 - 274 11 - 11 18 18 U.S. Government 172 (7) 165 3 (5) (2) 14 (8) 6 - - - 13 (157) (144) 865 (31) 834 Other foreign Governments 10 (5) 5 194 (25) 169 24 (18) 6 - - - 25 (6) 19 360 (6) 354 Designated Emerging Market Bonds - - - 73 - 73 - - - Mortgage-Backed Securities 81 (14) 67 - - - 19 - 19 - - - 13 (3) 10 8 - 8 Corporate Debt and Other 169 (18) 151 307 (73) 234 84 (18) 66 35 (2) 33 130 (175) (45) 538 (68) 470 Equity: 59 (3) 56 - 271 - 271 63 (11) 52 269 (18) 251 - Common - - - 551 (70) 481 ------117 (15) 102 Preferred - - - 18 (45) (27) ------38 - 38 Total AFS Securities 795 (86) 709 1,312 (219) 1,093 524 (48) 476 428 (13) 415 974 (359) 615 1,982 (121) 1,861 Total AFS debt securities 736 (83) 653 743 (104) 639 253 (48) 205 365 (2) 363 705 (341) 364 1,827 (106) 1,721 Total AFS debt securities % of Common Equity 2.8% -0.3% 2.5% 2.1% -0.3% 1.8% 1.7% -0.3% 1.4% 5.9% 0.0% 5.9% 1.8% -0.9% 0.9% 4.1% -0.2% 3.9%

2011 BMO BNS CM NA RY TD Gross Gross Gross Gross Gross Gross Gross Gross Gross Gross Gross Gross Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Unrealized Gains Losses Net Gains Losses Net Gains Losses Net Gains Losses Net Gains Losses Net Gains Losses Net Available-for-sale (AFS) securities Securities issued of guaranteed by: Canadian Federal Government 478 (40) 438 160 (5) 155 39 (7) 32 30 (6) 24 492 (1) 491 32 (3) 29 Canadian Other Governments 82 (79) 3 38 (4) 34 69 (2) 67 224 (1) 223 25 (1) 24 19 - 19 U.S. Government 248 (2) 246 - (2) (2) 8 - 8 - - - 11 (156) (145) 443 (51) 392 Other foreign Governments 13 (8) 5 242 30 272 40 (10) 30 - - - 26 (33) (7) 319 (7) 312 Designated Emerging Market Bonds 108 - 108 Mortgage-Backed Securities 124 (2) 122 - - - 46 (2) 44 - - - 19 (23) (4) 10 - 10 Corporate Debt and Other 56 (15) 41 254 (183) 71 37 (18) 19 39 (2) 37 66 (246) (180) 703 (160) 543 Equity: 78 (8) 70 - - - 323 (5) 318 126 (59) 67 207 (27) 180 - Common - - - 576 (157) 419 ------207 (35) 172 Preferred - - - 19 (53) (34) ------24 (39) (15) Total AFS Securities 1,079 (154) 925 1,397 (374) 1,023 562 (44) 518 419 (68) 351 846 (487) 359 1,757 (295) 1,462 Total AFS debt securities 1,001 (146) 855 802 (164) 638 239 (39) 200 293 (9) 284 639 (460) 179 1,526 (221) 1,305 Total AFS debt securities % of Common Equity 4.0% -0.6% 3.4% 2.8% -0.6% 2.2% 1.7% -0.3% 1.4% 4.6% -0.1% 4.4% 1.7% -1.2% 0.5% 3.5% -0.5% 3.0%

Source: Company reports, RBC Capital Markets

September 18, 2013 120 Canadian Bank Primer, Sixth Edition

Forecasting movements in the value of securities Forecasting writedowns on securities portfolios is a difficult exercise because it involves: 1) “guesstimating” what happened to the value of securities portfolios without knowing what the underlying securities are, or what hedges might be in place; and 2) “guesstimating” what banks may deem to be permanent on AFS (changes that are not deemed to be permanent hurt shareholders’ equity but not income). Normally, the following factors are negative:

 Widening of credit spreads (we track the spread of Moody’s Corp BAA Long Bonds over 10-year Treasury yields and the CDX North America Investment Grade Index) (Exhibit 94).  Widening of spreads on structured finance assets; which was more relevant in the 2007 – 2010 period (we track spreads on CMBS, ABX for home equity/RMBS values, and LCDX for corporate loans) (Exhibit 96).  Weak equity markets (we track the S&P/TSX Index and Canadian trading and financing activity) (Exhibit 95).  Widening of credit spreads on structured and/or leveraged product spreads (Exhibit 96).  Rising interest rates will lower the value of fixed income assets.

Exhibit 94: Spreads of US corporate bonds (cash) and investment grade CDS (derivatives) are well down from peak

US Credit Spreads (Corp BAA Long minus 10-yr Treasury Yields) Investment Grade CDS Spreads

650 300 600 250 550 500 200 450 150

400 Spread(bps)

Spread(bps) 350 100 300 50 250 200 - Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Moody's BAA 10yr North American European

Source: Bloomberg, RBC Capital Markets

Exhibit 95: The S&P/TSX YoY performance began to rebound in Q4/12

QTD (Bank fiscal quarters) Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 Q4/13 S&P/TSX Composite Index (EOP) 13,552 13,945 12,946 12,252 12,452 12,293 11,665 12,423 12,685 12,457 12,487 12,855 S&P/TSX Composite Index (Average) 13,173 13,938 13,358 12,163 12,073 12,383 11,585 12,173 12,379 12,596 12,433 12,655 YoY Growth (Average) 14% 17% 14% 0% (8)% (11)% (13)% 0% 3% 2% 7% 4%

Note: QTD Q4/13 as at September 9, 2013 Source: Bloomberg, RBC Capital Markets

September 18, 2013 121 Canadian Bank Primer, Sixth Edition

Exhibit 96: Spreads on corporate bonds and structured finance indices improved since 2009

10-Sep-13 CMBS (AAA spreads) LCDX Generic Spread QoQ Level QoQ 31-Jan-09 1,021 71% 78 -12% 30-Apr-09 840 -18% 81 5% 31-Jul-09 524 -38% 93 15% 31-Oct-09 442 -16% 98 5% 31-Jan-10 412 -7% 101 4% 30-Apr-10 234 -43% 99 -2% 31-Jul-10 253 8% 93 -7% 31-Oct-10 258 2% 98 6% 31-Jan-11 199 -23% 93 -5% 30-Apr-11 153 -23% 101 8% 31-Jul-11 199 30% 99 -2% 31-Oct-11 248 25% 94 -5% 31-Jan-12 202 -19% 97 3% 30-Apr-12 161 -20% 99 2% 31-Jul-12 149 -7% 99 0% 31-Oct-12 84 -44% 100 1% 31-Jan-13 79 -6% 102 2% 30-Apr-13 88 11% 103 1% 31-Jul-13 116 32% 103 0% Current 116 0% 104 1%

US Corporate Bonds CDX NA IG Index ABX HE-AAA-6-2 ABX HE-AAA-6-1 BAA spread QoQ Spread QoQ Level QoQ Level QoQ 31-Jan-09 541 -3% 199 -1% 46 -24% 76 -15% 30-Apr-09 518 -4% 162 -18% 33 -29% 69 -9% 31-Jul-09 300 -42% 111 -32% 40 21% 76 10% 31-Oct-09 301 0% 108 -2% 43 7% 80 5% 31-Jan-10 262 -13% 97 -11% 47 10% 81 1% 30-Apr-10 242 -8% 92 -5% 59 24% 90 10% 31-Jul-10 294 22% 104 13% 57 -3% 88 -1% 31-Oct-10 318 8% 94 -9% 59 4% 88 0% 31-Jan-11 273 -14% 84 -11% 60 2% 89 1% 30-Apr-11 261 -4% 88 4% 57 -6% 91 3% 31-Jul-11 279 7% 96 9% 54 -4% 90 -2% 31-Oct-11 308 10% 122 27% 44 -18% 87 -4% 31-Jan-12 327 6% 101 -17% 51 14% 90 4% 30-Apr-12 324 -1% 95 -6% 49 -3% 89 -1% 31-Jul-12 331 2% 108 13% 54 10% 92 4% 31-Oct-12 276 -17% 100 -7% 60 11% 94 2% 31-Jan-13 286 3% 89 -11% 68 13% 97 3% 30-Apr-13 286 0% 75 -16% 71 6% 98 2% 31-Jul-13 270 -5% 75 0% 72 0% 97 0% Current 254 -6% 78 5% 70 2% 97 -1%

VIX MOVE Average QoQ Average QoQ 31-Jan-09 53 39% 182 13% 30-Apr-09 43 -19% 140 -23% 31-Jul-09 29 -32% 151 8% 31-Oct-09 25 -14% 124 -18% 31-Jan-10 22 -12% 96 -23% 30-Apr-10 19 -12% 84 -12% 31-Jul-10 29 53% 94 12% 31-Oct-10 23 -23% 92 -1% 31-Jan-11 18 -19% 102 10% 30-Apr-11 18 -1% 91 -10% 31-Jul-11 18 1% 83 -10% 31-Oct-11 35 90% 102 23% 31-Jan-12 26 -26% 94 -8% 30-Apr-12 17 -32% 77 -17% 31-Jul-12 20 14% 71 -8% 31-Oct-12 16 -20% 66 -7% 31-Jan-13 16 0% 57 -14% 30-Apr-13 14 -14% 56 -1% 31-Jul-13 15 9% 80 41% QTD 16 17% 73 29%

Source: Bloomberg, RBC Capital Markets

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Exposure to illiquid securities are worth tracking as well Annual report disclosures from the Big Five Canadian Banks help quantify relative exposures to financial instruments that are valued primarily on models. We believe that financial instruments valued primarily on models are by their nature illiquid (whether they are securities or derivatives), and the valuations are subject to management assumptions.

The first category (Level 1) is made up of liquid financial instruments with quoted market prices. Inputs are quoted prices in active markets for identical assets or liabilities that the banks have the ability to access at the measurement date.

 Examples of Level 1 financial instruments include equities that are traded on stock exchanges, fixed income financial instruments in which markets are liquid, or publicly traded derivatives (Exhibit 97).

The second category (Level 2) of assets may not be as liquid, and valuations are based on a mix of market-based inputs and models-based assumptions. Inputs can include quoted prices for similar assets that are available in active markets or for identical instruments in markets that are less active where an adjustment is made for the thinness of the market.

 Most derivatives would be classified as Level 2 because they are privately negotiated but with values that are often determinable by looking at publicly available data such as equity index levels, interest rates, option volatility, foreign exchange rates, or commodity prices.

The third category (Level 3) includes illiquid financial instruments where valuations are based primarily on company assumptions (i.e., mark-to-model). Inputs are unobservable mainly because the instruments do not trade. They reflect the banks’ own assumptions about what market participants would assume in pricing the asset or liability (including assumptions for market risk and liquidity) based on the best information available.

 Many financial instruments that were the news from 2007 to 2009 found their way to Level 3 classification, including asset-backed financial instruments, CDO, ABCP, auction rate financial instruments, and leveraged buyout (LBO) loans. Other assets such as private equity investments, mortgage servicing rights, long-dated interest rate, or currency swaps would also be Level 3 assets.

September 18, 2013 123 Canadian Bank Primer, Sixth Edition

Exhibit 97: Example categories of financial instruments

Level 1 Level 2 Level 3 Quoted Securities Some use of market-corroborated inputs Models-based (significant unobservable market inputs)

Highly liquid government bonds Government bonds that are less frequently Private equity investments traded than exchanged traded instruments Exchange-traded equities Loans without observable pricing data (non-performing Corporate debt loans, sub-prime loans, leveraged lending funded Listed derivatives loans and unfunded commitments) Certain mortgage products and mortgage- backed positions Auction rate securities and certain illiquid municipal GICs Securities purchased under resale agreements Some structured credit products (e.g. synthetic CDOs) Some derivatives: interest rate swaps, options, credit default swaps, foreign currency forwards Asset-backed commercial paper

Most commodities contracts Long-dated interest rate or currency swaps

Certain CDOs / CLOs / CMOs with observable Equity options with no active market for underlying equity inputs

Source: Company reports, RBC Capital Markets

September 18, 2013 124 Canadian Bank Primer, Sixth Edition

Exhibit 98: Level 3-like financial instruments represent the smallest category for Canadian banks

Q2/13 (1) 2008 2007 Level 1 Level 2 Level 3 Level 1 Level 2 Level 3 Level 1 Level 2 Level 3 Observable Unobservable Observable Unobservable Observable Unobservable Quoted Market Market Quoted Market Market Quoted Market Market Issuer Total Price Parameters Parameters Total Price Parameters Parameters Total Price Parameters Parameters Canadian Banks (C$ millions) BMO $162,229 $77,415 $82,498 $2,316 $163,733 $78,299 $81,200 $4,234 $129,328 $83,734 $38,756 $6,838 % of Total 100.0% 47.7% 50.9% 1.4% 100.0% 47.8% 49.6% 2.6% 100.0% 64.7% 30.0% 5.3% BNS $169,401 $89,087 $76,460 $3,854 $131,925 76,926 52,818 2,181 $110,074 79,841 29,225 1,008 % of Total 100.0% 52.6% 45.1% 2.3% 100.0% 58.3% 40.0% 1.7% 100.0% 72.5% 26.6% 0.9% CM 98,244 30,863 64,991 2,390 102,057 41,456 54,463 6,138 113,600 71,434 35,107 7,060 % of Total 100.0% 31.4% 66.2% 2.4% 100.0% 40.6% 53.4% 6.0% 100.0% 62.9% 30.9% 6.2% NA 63,498 21,753 40,072 1,673 % of Total 100.0% 34.3% 63.1% 2.6% RY $300,287 $64,743 $227,122 $8,422 $339,865 119,108 197,504 23,253 276,367 145,211 130,580 576 % of Total 100.0% 21.6% 75.6% 2.8% 100.0% 35.0% 58.1% 6.8% 100.0% 52.5% 47.2% 0.2% TD $236,087 $44,306 $188,849 $2,932 216,662 43,131 160,803 12,728 152,922 52,105 100,041 776 % of Total 100.0% 18.8% 80.0% 1.2% 100.0% 19.9% 74.2% 5.9% 100.0% 34.1% 65.4% 0.5%

US Banks (US$ millions) BAC $1,889,357 165,485 1,688,494 35,378 $2,041,276 $74,876 $1,906,991 $59,409 $516,934 $57,865 $448,234 $10,835 % of Total 100.0% 8.8% 89.4% 1.9% 100.0% 3.7% 93.4% 2.9% 100.0% 11.2% 86.7% 2.1% C $1,762,516 221,478 1,489,247 51,791 1,734,611 144,547 1,444,117 145,947 1,290,337 223,263 933,639 133,435 % of Total 100.0% 12.6% 84.5% 2.9% 100.0% 8.3% 83.3% 8.4% 100.0% 17.3% 72.4% 10.3% GS $734,661 175,729 512,909 46,023 729,841 85,410 584,857 59,574 766,557 138,209 573,634 54,714 % of Total 100.0% 23.9% 69.8% 6.3% 100.0% 11.7% 80.1% 8.2% 100.0% 18.0% 74.8% 7.1% JPM $2,309,452 213,456 2,028,639 67,357 3,344,341 301,333 2,933,921 109,087 635,500 287,082 295,067 53,351 % of Total 100.0% 9.2% 87.8% 2.9% 100.0% 9.0% 87.7% 3.3% 100.0% 45.2% 46.4% 8.4% MS $397,742 163,285 213,964 20,493 374,832 55,062 236,125 83,645 497,398 183,197 240,542 73,659 % of Total 100.0% 41.1% 53.8% 5.2% 100.0% 14.7% 63.0% 22.3% 100.0% 36.8% 48.4% 14.8% WFC $433,402 17,598 374,007 41,797 416,236 10,380 350,299 55,557 110,735 34,928 53,239 22,568 % of Total 100.0% 4.1% 86.3% 9.6% 100.0% 2.5% 84.2% 13.3% 100.0% 31.5% 48.1% 20.4%

1) For US banks, data as of March 31, 2013 Source: Company reports, RBC Capital Markets

September 18, 2013 125 Canadian Bank Primer, Sixth Edition

We believe that the disclosures are useful in the following ways:

They provide insight on which banks may be more exposed to less liquid financial instruments, with Level 3 financial instruments being least liquid. Having illiquid assets does not necessarily mean having lower-quality assets (from a credit perspective), but it means that liquefying the assets, if needed, would likely be more difficult. Banks mark financial instruments to model regularly—there is nothing inherently wrong with that concept. If a bank were forced to sell all its financial instruments, however, there is a greater chance of realizing a sale price that is different from accounting values for Level 3 assets than Level 1 and 2 assets.

Growth in Level 3 assets is useful to track as an increase indicates an increase in illiquid assets.

 The growth may be “desired” if it represents the purchase of financial instruments where a bank understands that the financial instruments are illiquid.  Growth that comes from vanishing market liquidity is clearly undesirable as it increases risk of markdowns, in our view, and it forces banks to rethink how the assets are funded (actively traded financial instruments are normally funded with short-term liabilities; an asset that becomes a longer-term duration needs to be funded with longer-term liabilities unless a bank wants to be exposed to interest rate risk).

September 18, 2013 126 Canadian Bank Primer, Sixth Edition

Exhibit 99: Level 3-like instruments are larger for US banks as a proportion of common equity

Q2/13(1) 2012 Q3/12(1) Financial Assets as a Level 1 Level 2 Level 3 Level 1 Level 2 Level 3 Percentage of Common Equity Observable Unobservable Observable Unobservable Common Quoted Market Market Common Quoted Market Market Issuer Equity Price Parameters Parameters Equity Price Parameters Parameters Canadian Banks (C$ millions) BMO $ 27,080 286% 305% 9% $ 26,190 354% 302% 11% % of Total Trading Securities 46,609 25,293 1,344 48,008 20,247 1,854 Available for Sale 30,084 14,901 935 43,460 11,929 993 Derivatives 722 42,304 37 1,194 46,832 45

BNS 38,012 234% 201% 10% 35,252 202% 216% 10% % of Total Trading Securities 67,646 34,957 1,420 53,092 33,031 1,373 AFS Securities 20,694 12,749 2,029 17,094 14,255 1,822 Derivatives 747 28,754 405 1,118 28,838 371

CM 15,638 197% 416% 15% 15,160 190% 407% 19% % of Total Trading Securities 29,061 17,542 852 26,611 13,984 640 AFS Securities 1,570 22,604 1,123 1,903 21,427 1,370 FVO financial instruments --- 38 ------172 170 Derivatives 232 24,807 415 245 26,111 683

NA 6,990 311% 573% 24% 6,458 360% 584% 25% % of Total Trading Securities 20,652 23,210 1,394 21,724 21,474 1,326 AFS Securities 800 9,453 240 1,114 8,900 270 Derivatives --- 1,256 ------1,110 (3) FVO financial instruments 301 6,153 39 407 6,242 47

RY 41,438 155% 547% 20% 39,453 155% 542% 23% % of Total Trading 57,781 80,738 1,267 52,212 67,261 1,310 Derivatives 2,378 120,393 786 2,075 120,330 862 FVO financial instruments 474 421 12 --- 829 403 Avallable for Sale 4,110 25,570 6,357 6,929 26,432 6,941

TD 46,272 96% 408% 6% 44,128 114% 463% 7% % of Total Trading Securities 38,519 55,889 206 43,286 51,009 236 Designated Trading Sec ------Available for Sale 5,454 73,707 1,910 6,855 89,886 1,830 Derivatives 333 59,253 816 216 63,630 1,151

US Banks (US$ millions) BAC $ 216,791 76% 779% 16% $ 218,188 79% 855% 17% C 191,633 116% 777% 27% 186,487 99% 868% 26% GS 68,005 258% 754% 68% 70,024 272% 717% 67% JPM 198,034 108% 1024% 34% 195,011 109% 1107% 51% MS 62,841 260% 340% 33% 62,109 260% 343% 33% WFC 149,824 12% 250% 28% 145,582 9% 244% 36%

1) US banks as of March 31, 2013. Source: Company reports, RBC Capital Markets

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SECTION 6: Wealth management: Profitable contributor The wealth management divisions of the banks, which contribute 10–20% of income in normal times, generate most of their revenues from retail brokerage and asset management, mainly mutual funds. The banks also provide private client and trust services, but those are not as meaningful in contributing to the bottom line. The key links between all those businesses are as follows:

 A significant proportion of the assets managed and/or administered is invested in equities. Equity markets are expected to rise in time, and, to the extent that a large proportion of revenues are driven by asset levels, revenue growth benefits. Rising equity markets also tend to lead to more trading activity by retail clients, a positive for commission revenues.  Demographic trends suggest faster growth for wealth management assets than traditional banking products. Baby boomers are no longer at an age at which borrowing needs are crucial; they are accumulating wealth as mortgages are paid off and children are out of the house. As boomers continue to age, principal protection and income protection become increasingly important.  Capital requirements to support revenue sources are generally low compared to traditional banking businesses.

Investors normally value wealth management companies at higher multiples than traditional banking and/or investment banking (Exhibit 100). The reasons for the higher valuations are:

 Growth has been greater than in traditional banking products,  Profitability is higher than traditional banking products given lower capital requirements,  Volatility of income is lower than credit-driven and trading businesses, and  Appreciation in equity markets provides long-term revenue growth for fee-based assets, even in the absence of net new sales.

We believe that the appeal of wealth management divisions has increased even more given increased capital requirements for capital markets businesses and a likely decline in personal credit growth compared to the 2000s.

September 18, 2013 128 Canadian Bank Primer, Sixth Edition

Exhibit 100: Wealth management companies are typically valued at higher multiples

P/E Comparison: Wealth Management, Investment Banks, Diversified Banks (2004 - July 2013) 25x

21x

17x

13x

5x Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

SP500 Asset Management & Custody Banks P/E (forward) SP500 Investment Banking & Brokerage P/E (forward) SP500 Diversified Banks P/E (forward)

Source: Bloomberg, RBC Capital Markets Quantitative Research, RBC Capital Markets

Wealth management revenues have grown quickly in the last 10 years, driven by added products and services, expanded distribution, and a solid equity-market backdrop. We expect that banks will continue to have an outsized effort to grow their wealth management businesses given the high returns and the valuations those businesses are awarded. As such, we expect wealth management revenues to continue growing as a proportion of revenues in time. Notwithstanding the solid long-term drivers of growth in wealth management revenues, the short-term revenue trends in wealth management revenues are heavily influenced by equity-market direction, which has been improving recently (Exhibit 101).

Exhibit 101: Wealth management revenues have grown in line with equity markets

Mutual Fund Revenue Growth vs. SPTSX Growth Total Big 6 Bank Mutual Fund Revenue vs. SPTSX (Quarterly since 2003) Correlation coefficient: 0.72 (Quarterly since 2003) 30% Correlation coefficient: 0.69 16,000 2,000

1,800 20% 14,000 1,600 12,000 10% 1,400 10,000 1,200 0% 8,000 1,000

800 6,000 -10% 600 4,000 400 -20% 2,000 200

-30% 0 0 2Q03 2Q04 2Q05 2Q06 2Q07 2Q08 2Q09 2Q10 2Q11 2Q12 2Q13 2Q03 2Q04 2Q05 2Q06 2Q07 2Q08 2Q09 2Q10 2Q11 2Q12 2Q13

Mutual Fund Revenue QoQ growth SPTSX Index Average QoQ Growth S&P TSX Level (LHS) Mutual Fund Revenue (C$, millions)

Source: Bloomberg, company reports, RBC Capital Markets

September 18, 2013 129 Canadian Bank Primer, Sixth Edition

Exhibit 102: Wealth revenue growth is influenced by equity market direction in the short term

(Bank fiscal quarters) Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 S&P/TSX Composite Index (EOP) 13,552 13,945 12,946 12,252 12,452 12,293 11,665 12,423 12,685 12,457 12,487 S&P/TSX Composite Index (Average) 13,173 13,938 13,358 12,163 12,073 12,383 11,585 12,173 12,379 12,596 12,433 YoY Growth (Average) 14% 17% 14% 0% (8)% (11)% (13)% 0% 3% 2% 7% Banks' wealth revenue YoY change 14% 24% 17% 15% 8% 7% 3% 6% 10% 2% QoQ Growth (Average) 9% 6% (4)% (9)% (1)% 3% (6)% 5% 2% 2% (1)% Banks' wealth revenue QoQ change 19% 10% (6)% 2% 2% 9% (9)% 5% 5% 2%

Source: Company reports, Bloomberg, RBC Capital Markets

Canadian banks are the leaders in retail brokerage Retail brokerage operations comprise both full-service and online brokerages.

 Full-service brokers (vs. online/discount brokers) have 76% market share of brokerage industry assets and 82% of industry revenues, which in the last decade has remained generally unchanged on a revenue basis and is down slightly on an asset basis (Exhibit 103).  The Big Five Banks have over 70% market share of full-service brokerage assets and more than 85% of the online-discount broker industry, according to Investor Economics.  Full-service and online-brokerage trading commissions have benefited from a trend toward higher trading activity, but pricing has been coming down for years and is expected to continue to decline. Historically, trading activity was the main short-term driver of volatile revenues, with trading activity tending to be positively correlated with equity market direction (Exhibit 104). During the market volatility of 2007-2011, however, trading activity continued to climb. 2012 was a challenging year for the full service brokerage industry which was hit with a double whammy in that pricing pressure continued to prevail, but trading activity mimicked the broader decline in industry trading volumes despite the S&P/TSX Composite Index being positive for the year.  The proportion of revenues that is generated from non-trading sources (management fees, mutual fund trailer fees, and net interest income) has risen, which should lead to a reduction in revenue volatility.

Exhibit 103: Full-service brokers have 76% market share of retail brokerage industry assets

$1,000 $862 $800

$600 $399 $400

$266 assets ($blns) assets

$200 $108 Retail brokerageRetail industry $0 December 2002 March 2013 Online / discount brokers Full service brokers

Source: Investor Economics, RBC Capital Markets

September 18, 2013 130 Canadian Bank Primer, Sixth Edition

Exhibit 104: Trading activity tends to be positively correlated with equity market direction

120,000 120,000 100,000 100,000 80,000 80,000 60,000 60,000 40,000 40,000 20,000 20,000

0 0

1999 2000 2002 2004 2005 2006 2007 2008 2009 2011 2001 2003 2010 2012

Number of trades S&P/TSX Composite Total Return Index Source: Investor Economics, RBC Capital Markets

Full-service brokerage is less dependent on transactions than in the past With their full-service brokerage businesses, banks provide investment and wealth management advice to individuals with at least $300,000–$400,000 in investable assets (investors with investable assets below that threshold are generally served through branch- based financial planners with a heavy emphasis on mutual funds and GICs). Historically, retail brokers were viewed primarily as stock traders, with their livelihood based on how much trading activity they generated. The business has changed in the last 20 years as: (1) the emergence of discount brokerage has challenged the commission structure of retail brokers; (2) the growth of the mutual fund industry has allowed retail investors to access institutional money management; and (3) there has been an increased realization by retail investors and the banks (that now own the retail brokerage houses) that investor and broker interests can be misaligned if compensation is solely based on trading activity. Today’s brokers are also more likely than has historically been the case to remove themselves from the stock-picking process, therein shifting clients’ assets toward professionally managed solutions such as fund wraps.30 This shift allows them to spend more time on client acquisition, financial planning, and client servicing.

Profitability is broadly driven by the following:

 Commission-based revenues now account for 37% of full-service brokerage revenues, down from 55% in 2002 as fee-based revenues grew. 52% of full-service brokerage revenues today are fee-based (typically a percentage of investable assets), a jump from 31% in 2002), according to Investor Economics. (Exhibit 105).  Fee-based revenues are generated from account fees, management fees on discretionary accounts, and trailer fees on 3rd party managed assets such as mutual funds. Banks also generate interest income from cash balances and margin loans. The declining proportion of revenues coming from commissions has positive implications for future volatility because fee-based revenues as well as net interest income should be less volatile.

30 Fund wraps, a type of “fund-of-fund” product, are fee-based products that invest in a variety of underlying mutual funds. Wrap products are often administered by professional money managers who are responsible for rebalancing activities. September 18, 2013 131 Canadian Bank Primer, Sixth Edition

 Management and trailer fees tend to be positively correlated with equity markets and net interest income positively correlated with the level of short-term rates (banks are able to generate higher spreads on deposits in higher short-term interest rate environments).  Retail brokerage divisions are also allocated a share of the banks’ underwriting revenues, to the extent that they were involved in distributions (e.g., corporate equity and debt financings).  Costs related to full-service brokerage are high as a percentage of revenues (70–80%). They include technology, compliance, and physical infrastructure, but the biggest would be commissions to brokers. Brokers keep a material portion of what they generate in fees (40–50%), which mitigates bottom-line volatility compared to discount brokerage but, at the same time, limits margin upside when revenues are growing.

Exhibit 105: Fee-based revenues are now 52% of revenues for full-service brokers

4% 1% 100% 12% 11% 80% 15% Increasing % of fee- based revenues

60% 52%

revenues

service brokerage - 40% 69%

% of full of % 20% 37%

0% 2002 2012 Commissions Fees Spread income Other revenues

Source: Investor Economics, RBC Capital Markets

To succeed in retail brokerage, banks need quality advisors who have well established relationships with affluent clients. Banks must have active recruitment, training programs, retention incentives, and products, tools, and support that make their brokerage firm the place to be for advisors. Banks must also convince advisors that working for a bank-owned broker is more attractive than working for independent boutiques, with the benefits (relative to independents) of working for a bank-owned broker including:

 Banks with capital markets businesses can bring new-issue flow to retail brokers. Also, banks with large retail-brokerage networks are in a stronger position to obtain larger pieces of share issues for their capital markets businesses because they provide an important source of potential demand for new issues.  Banks with stronger retail distribution are in a position to refer business to their retail brokers, but managing incentives at the branch level to encourage referrals is a process that will forever need tweaking, in our view.  Training programs tend to be more developed and the product package broader than at boutiques.  As the 2008–2009 downturn in equity markets exposed numerous investor fraud and Ponzi schemes, investors may increasingly seek to deal with large, reputable, retail- brokerage firms.

September 18, 2013 132 Canadian Bank Primer, Sixth Edition

Online brokerage – High fixed costs equate to high operating leverage The online brokerage business is aimed at customers who want to take more control of their investing and trading activities. The support and service that investors receive is lower than if they dealt with full-service brokers, but the cost of executing transactions is much lower.

 We believe that the online industry’s heyday is behind it in terms of new account growth because the pent-up demand for low-cost investing accounts was satisfied in the late 1990s when the Internet mushroomed. We believe that the growth in new accounts will be slower, but we expect invested assets per account to grow.  The first wave of account openings was driven by younger people looking to trade actively, or older and wealthier individuals looking for a less expensive way to trade in their spare time, while keeping most of their assets invested with full-service brokers.  We believe that the new generation of emerging affluent individuals will be much more comfortable with technology and the do-it-yourself model of investing, and as such, online brokerages should benefit.

Revenues are mainly generated from trading commissions, trailer fees, and net interest income. In the last decade, the revenue mix has become less dependent on trading commissions, which should be a positive for volatility of revenues (Exhibit 106).

 Trailer fees come from mutual fund holdings in client accounts. The asset managers pay a small trailer fee to the brokerage company, which provides a steadier source of income than commissions. Revenues fluctuate with asset values. A relatively more recent development to appeal to investors seeking low cost mutual funds has been some fund companies offering versions of their mutual funds (sometimes called “D- series” versions) which do not pay the trailer fee to the online/discount brokerage); however, we believe there has not been significant growth in this segment in part due to most fund companies not offering this fund type.  Net interest income is generated from cash balances, which the brokers invest at higher returns than they pay out, and margin loans, which are used by investors to buy stocks. We believe that spreads are attractive for both cash balances and margin loans because we do not believe customers select their discount-brokerage accounts based on margin rates or deposit rates and, as such, are probably less price-sensitive than one may think, particularly since there is no competition at the point of sale. With that said, the low interest rate environment has undoubtedly compressed the spread earned on cash balances in the last few years (which should reverse when short-term rates rise). For example, TD Ameritrade holds or manages $94 billion of interest rate sensitive assets, such as spread-based assets and money market mutual funds. Those assets would be more profitable in a higher interest rate environment: the company estimates that an interest rate increase of 100 basis points would positively impact EPS by about $0.32 (or ~28% of annual EPS) in the first 12 months, and the impact would rise to +$0.50 in the third year.  Commission revenue has benefited from increased trading activity but has been offset by significant pressure on pricing. We expect continued declines in prices for trade execution as brokers gain more scale, technology becomes less expensive, and competition continues to be a factor. In the near term, we believe that the most useful indicator of trading activity is market volatility.  Operating expenses relate mainly to technology, call centre staffing, communication, and advertising (although the advertising is almost non-existent by US standards because the Canadian discount brokers rely on their banks’ brands and branch networks to attract customers). Many of the costs are fixed, which leads to very high

September 18, 2013 133 Canadian Bank Primer, Sixth Edition

incremental profitability on marginal trades for scale players. This situation is in sharp contrast to the full-service brokerage side of the business, where advisors share in the revenue upside (and downside).

Exhibit 106: The proportion of revenues coming from commissions has declined

100%

80%

60%

revenues) 40%

20%

Commission revenues (% of online/discount brokerage LTM 0% Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

Source: Investor Economics, RBC Capital Markets

Banks’ positioning in Canadian mutual funds is strong The banks have become leading players in the Canadian mutual fund industry. During the 10 years leading to 2009, the Canadian banks collectively increased their mutual fund net sales market share by a significant amount (and maintained it since), partly through increased focus on growing their wealth management platforms and also through better execution of this strategy (banks broadened their mutual fund line-ups beyond traditional Canadian equity and balanced funds, and they increased the number of qualified salespeople that they employ in branches). The banks’ market share gap will likely widen further as banks look for areas of growth in areas that demand little capital.

 The Big Five Canadian Banks’ market share of the mutual fund industry long-term fund net sales (i.e., excludes money market funds) today typically exceeds 75%, compared to 10–20% in the mid-to-late 1990s.

Exhibit 107: The Big 5 banks have gained market share in long-term fund net sales

100%

80%

60% share 40%

20% Big 6 bank 6 bank Big net sales market

…

LTM

1997 1998 1999 2000 2001 2002 2004 2005 2007 2008 2009 2010 2011 2012 2003 2006 1996

Source: Investor Economics, RBC Capital Markets

September 18, 2013 134 Canadian Bank Primer, Sixth Edition

 It is important to note that despite garnering a majority of long-term fund net sales, the Big Five Banks still collectively comprise only 42% of the industry’s AUM, which is the key driver of profitability. The Big Five Canadian banks have increased their collective AUM market share by about 100 basis points per year, in part driven by acquisitions. In recent years, for example, Royal Bank purchased Canadian asset manager Phillips Hager & North, while Scotiabank bought DundeeWealth.

Mutual funds are attractive products for customers looking for diversified exposure to equity and fixed-income markets, and who need the product delivered via an advice channel. We believe that banks are well positioned to continue capturing an attractive share of this market.

 Since 1995, the Canadian mutual fund market grew by a 10.6% compound annual rate (measured by AUM) with current AUM of about $965 billion. (Exhibit 109)  Mutual funds tend to be most popular with mass-market customers (the banks’ bread and butter) because higher-net-worth individuals tend to gravitate toward retail brokerage, private-counsel platforms, and hedge funds. Strong brand recognition and reputation, as well as competitive mutual fund pricing, also position the banks well in the mutual fund arena.  Mutual funds tend to be sold, not bought, so access to distribution is crucial. The Canadian banks have formidable distribution networks by which they can sell mutual funds, compared to many of their competitors.  There are many benefits to owning distribution networks (i.e., bank branches, investment advisors, and financial planners) including: (1) greater asset-management margin and net-sales stability; (2) a greater ability to fill a higher proportion of fund shelf space with proprietary funds; and (3) easier access to advisors, particularly during periods when investments underperform.  Generally, mutual fund companies that own distribution networks manage approximately 70% of the industry’s AUM and in recent years had a collective market share of industry net sales of almost 100% owing to the fact that most independent fund companies have been in net redemptions for some time.  The gap in collective net-sales performance for mutual fund companies that own distribution has widened significantly since the start of 2004.(Exhibit 108)

Exhibit 108: Fund companies with proprietary distribution have gained share of net sales

$40

$30

$20

$10

term term mutual fund

net salesnet ($B) -

$0 Long ($10) Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

Distribution ownership No distribution ownership

Note: Trailing 12-months as at July 31, 2013. Source: Company reports, IFIC, Investor Economics, RBC Capital Markets

September 18, 2013 135 Canadian Bank Primer, Sixth Edition

Exhibit 109: Canadian mutual fund industry AUM is now about $965 billion

$1,000 $100

$800 $80

$600 $60

$400 $40 ($B)

$200 $20

$0 $0

($200) ($20) fund Mut'l industry net sales

…

Mutual fund fund Mutual industry AUM ($B)

LTM

1997 1999 2000 2001 2003 2004 2005 2007 2008 2009 2011 2012 1998 2002 2006 2010 Mutual Fund Industry AUM (LHS) Mutual Fund Industry Net Sales (RHS)

Note: Current net sales are for the last 12-month period (until the end of March 2013). Source: Company reports, IFIC, RBC Capital Markets

The profitability model for mutual fund companies is fairly straightforward:

 Mutual fund companies charge a fee on mutual fund assets managed, which consists of management fees and fund operating costs (e.g., legal, audit, trustees, custodial, other administrative, etc.). These fees are typically expressed as a percentage of AUM and referred to as management expense ratio (MER). MER can vary, but an average equity mutual fund (excluding money market funds) might have a MER of 2.20%, balanced (2.00%), and fixed income (1.35%).  The main expenses for a mutual fund company are: (1) distribution costs [e.g., trailer fees and/or commissions paid to financial advisors who sell the mutual funds, which average about 1.00% of assets for equity funds sold in advice channels—funds sold with larger upfront commissions tend to have lower trailers and vice-versa]; (2) marketing, advertising, and infrastructure costs [which have a large fixed-cost component] and investment management [a fixed cost for players with scale]; and (3) for most companies, fund operating expenses.  Larger companies’ margins benefit from scale because a good component of expenses is fixed.  EBITDA margins for just the asset management business vary but can exceed 50% of revenues for the large mutual fund companies (greater than $50 billion in mutual fund AUM).

We expect banks to continue to target growth in their mutual fund business given the attractive margins, high ROE, recurring fee model, and attractive growth characteristics. We believe the banks are capable of increasing their market share of mutual fund industry net sales by increasing penetration of their retail customers via:

 Retooled incentives at the branch level (which already account for 40–60% of the banks’ sales of mutual funds);  Systems that make it easier for branch-based personnel to sell the funds;  Larger internal sales forces; and  Further exploit their generally lower MERs (compared to non-bank competitors) by reducing fees, thereby, with all else being equal, increasing the value proposition of their mutual funds.

We also believe that the banks will target the independent financial planner as well as investment advisor networks even more than they already have. This is not an easy battle for the banks to win, but success would greatly expand their potential sales.

September 18, 2013 136 Canadian Bank Primer, Sixth Edition

SECTION 7: Loan losses can be material, but exposure has declined Past credit cycles resulted in severe losses for Canadian banks and banks will always have credit risk as it is one of the primary reasons why they exist, so it is important to take credit risk into consideration when investing in banks. This section focuses on:

 How banks are exposed to credit risk;  The variability in credit risk by loan category and useful predictive loss metrics;  How to use available disclosures to predict credit losses;  Key credit ratios;  Accounting for credit-related items under IFRS; and  Our outlook for loan losses in upcoming years.

For Canadian GAAP accounting for credit-related items, please see the fourth edition of our primer, published on August 16, 2011.

Credit risk is the risk of financial loss due to a borrower or counterparty failing to meet its obligations in accordance with agreed terms.

 Credit risk accounts for approximately 80% of Canadian banks’ regulatory capital requirements.  Credit risk is traditionally thought of in the context of the banks’ large loan portfolios, but it can also occur in areas such as derivatives through written credit-default swaps or counterparty risk, guarantees, and reinsurance. Loan books represent a smaller proportion of bank balance sheets than in the past.  Since banks hold fixed-income securities (in trading businesses, corporate treasury books, or investment portfolios), credit risk also arises when bond issuers default and do not pay the principal and interest owed. Counterparty risk as it pertains to trading books and derivative transactions is discussed in “Section 5: Wholesale banking is banks’ second-largest division”. Banks are more exposed to those risks than they were in the past.  There are many different ways to reduce credit risk, including conservative underwriting practices, active loan sale programs, use of collateral agreements or hedging instruments, purchasing bulk insurance, or transacting with higher-quality counterparties and in higher-quality underlying assets.

Traditional credit risk (i.e., in loan books) ultimately comes down to three factors, in our view:

 Does the borrower have enough cash flow to cover financing costs? Two things matter: 1) cash flow levels, which are roughly equivalent to income levels for individuals; and 2) financing expenses, which are driven by the size of debt balances and the cost of that debt (a function of interest rates, and the spread between borrowing costs and reference interest rates31). These statistics are generally not disclosed by individual banks, but they are available on a national level. The debt-service burden for Canadian consumers is lower than it was in the early 1990s because lower interest rates have

31 For example, retail loans are often priced against the prime rate, with variable mortgage rates typically below prime (although recently discounts to prime rates on mortgages are rare) and unsecured loans higher than prime. The prime rate is the best lending rate given to credit-worthy customers. It fluctuates with the cost of funds influenced by Bank of Canada’s key policy rate called the target overnight rate. For business lending, many loans are priced in reference to the London Interbank Offered Rate (LIBOR). LIBOR is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market. September 18, 2013 137 Canadian Bank Primer, Sixth Edition

offset higher levels of borrowing against disposable income. Businesses also have better debt-servicing capacity today compared to the early 1990s, helped by lower interest rates and less levered balance sheets (Exhibit 110 and Exhibit 111).

Exhibit 110: Canadian consumer debt servicing has improved from the 1990s even as debt-to-income rose

Household Debt Service Burden Household debt to Personal disposable income (Since 1990) % (Based on credit market debt) 15% 180

14% On average, U.S. households spend 14% of their personal disposable income (PDI) on 160 13% healthcare vs. 4% in Canada due to differences in each country's healthcare 12% system. Deducting this "core" expense from 140 PDI, U.S. household debt to PDI is approximately 6% higher than Canada. 11%

10% 120

100 8%

7% 80 6%

5% 60 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada Gross Debt Service Burden U.S. Gross Debt Service Burden Canada U.S. U.K. Australia

Note: Canadian, US, and U.K. data within the above exhibits are not always perfectly comparable. Comparing the trends would be more useful than comparing absolute levels. Debt-service burden: debt-related payments (principal and interest) as a percentage of personal disposable income. Source: Bank of Canada, Statistics Canada, RBC Economics, RBC Capital Markets

Exhibit 111: Canadian corporate interest coverage has improved during the last 20 years

Corporate Interest Coverage Ratio (Since 1985) 25x

20x

15x

10x

0x 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Canadian Corporate Interest Coverage Ratio (EBITDA/interest payments) U.S. Corporate Interest Coverage Ratio (EBITDA/interest payments)

Note: Canadian and US data within the above exhibits are not always perfectly comparable. Comparing the trends would be more useful than comparing absolute levels, in our view. Source: Statistics Canada, RBC Economics, RBC Capital Markets

 If the borrower’s cash flow is not sufficient to cover financing costs, then is the balance sheet strong enough and liquid enough to repay the loan? The key issue is leverage. Again, banks do not disclose enough information for outsiders to assess the quality of their loan books on this metric, but metrics are available on a national basis. Canadian individuals’ debt-to-assets ratio has risen to ~20% from 16% in 2000 and 18% in 1990, while businesses’ debt-to-equity ratios are down to about 170% from 185% in 2000 and 230% in 1990. (Exhibit 112)

September 18, 2013 138 Canadian Bank Primer, Sixth Edition

 If the borrower fails to repay a loan, does the bank have access to collateral that it can sell to recover some or all of its entire loan? We know that a good proportion of their loans are secured by assets (including, of course, all mortgages), but we cannot know exactly how much or how readily liquidated the collateral would be if it needed to be sold. Banks may also have other sources of repayment on borrower default, including if the loans were insured, such as some Canadian mortgages, or if the loans were hedged, such as on some corporate loans.

Exhibit 112: Canadian household leverage has increased, while Canadian corporate leverage has declined

Corporate Leverage Household Debt (Since 1990) (Since 1990) 23% 300%

22%

21% 270%

20%

19% 240%

18%

17% 210%

16%

15% 180%

14%

13% 150% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canadian Household debt as % of Assets U.S. Household debt as % of Assets Canadian Corporate Debt-to-Equity Ratio U.S. Corporate Debt-to-Equity Ratio

Note: Canadian and US data within the above exhibits are not always perfectly comparable. Comparing the trends would be more useful than comparing absolute levels, in our view. *US ratio re-based to start with Canadian ratio; US and Canadian data as of March 31, 2013. Source: RBC Economics, Statistics Canada, RBC Capital Markets

Credit risk often hurts banks in areas that they do not expect, and they are often caught off guard by rapid deterioration in a geography, industry, or issuer. Different loan categories have hit the banks at different times in the past. For example, the credit issues in the early 1980s were driven by a global recession that affected corporate and consumer portfolios, followed by writeoffs in loans to less-developed countries in the mid-to-late 1980s, commercial real estate in the early 1990s, corporate loans to the telecom, media, and energy sectors in the early 2000s, and US residential mortgage-related loan exposures in late 2007 and 2008 (which then spread to other loan categories, particularly those related to consumer lending and residential construction). Diversification is crucial because banks that fail due to credit-related issues are usually those that are overexposed to weak areas in a credit downturn.

Banks will always have credit risk, but Canadian banks are less exposed to traditional credit risk (i.e., loan losses) than in the past because loans comprise a lower percentage of balance sheets than before and banks have more exposure to revenues generated outside lending.

 Loans make up just over 50% of assets today compared to over 70% in the 1980s and early 1990s, and loans as a multiple of common equity (excluding residential mortgages) have declined to 6x today from 22x in the early 1980s and 12x in the early 1990s (Exhibit 40 and Exhibit 113).  In the peak year for loan losses in the early 1990s, losses represented 26% of revenues (and were even higher at 55% in 1987). In the early 2000s, they represented 15%, and in 2009 14%.

September 18, 2013 139 Canadian Bank Primer, Sixth Edition

Exhibit 113: Gross loans have declined as a percentage of assets

Gross Loans as % of Total Assets (Annual since 1970) 80%

70%

60%

50%

40%

30% 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14E

Gross Loans as % of Total Assets

Canadian banks began reporting under IFRS in 2012 with results restated for 2011, resulting in loans (mostly mortgages) coming on balance sheet. Total Big Six Banks. Source: Company reports, RBC Capital Markets

Lower exposure to loan losses does not mean that the banks are necessarily less exposed to total losses, including writedowns on securities, but it does mean that the negative effect of rising loan losses alone on ROE should be lower than in past credit cycles. For example, in the 2008–2010 cycle, losses related to securities occurred even as loan losses remained low in the early part of the cycle since securities are marked to market and asset values declined early. By the time loan losses rose and peaked in 2009, the worst of securities writedowns was behind; therefore, the peak-to-trough ROE decline was lower, although the initial decline in ROE started earlier in the economic cycle than in the past.

 While banks are less exposed to credit risk than in the past, they have become more exposed to mark-to-market risk because they have increased non-lending assets and more loans, and securities are designated as held for trading. From 2007 to 2009, the Big Six Canadian Banks incurred $23 billion in separately disclosed writedowns in their securities books and trading. Those writedowns occurred primarily because of the deteriorating values for structured-finance assets and valuation allowances for trading counterparties. Credit losses were low compared to historical experiences in credit downturns. In contrast to prior periods in which profitability declined because of the effect on credit losses of an economic slowdown, Canadian banks were more affected by trading losses because they are more exposed to securities that are marked to market in anticipation of future credit events.

Canadian banks should also be helped by having business loans that represent a smaller proportion of their balance sheets than in prior cycles. Business and government loans make up 26% of total loans today compared to 50% in the early 1990s and 70% in the early 1980s. Business loans have historically exhibited more volatility in loss ratios, and in weak periods, those loss ratios have been higher than in consumer or mortgage lending. In 2009, however, losses peaked higher due to consumer loan provisions (Exhibit 114).

Canadian banks’ increased revenue diversification should also help in recessions. More of their revenues are generated from areas that generate no credit risk (advisory fees, management fees, and commissions), and those revenues are the “first line of defence” against rising credit losses. Furthermore, the greater exposure to wholesale businesses was a negative early in the most recent cycle because securities writedowns were costly, but it proved to be a positive later in the cycle: by the time loan losses were rising in retail and commercial lending, the profitability of wholesale businesses was strong. September 18, 2013 140 Canadian Bank Primer, Sixth Edition

Exhibit 114: Loan losses are cyclical; the most recent cycle was more consumer-led than prior cycles

Loan Loss Provisions Provisions for Credit Losses by Product (Annual since 1977) (Annual since 1990) 3.5% 3.0% Average PCLs (since 1990): Residential Mortgages: 0.03% 3.0% 2.88% 2.5% Consumer Loans: 1.06% Business and Government Loans: 0.73% 2.5% 2.0% Total Loans: 0.58%

2.0% 1.5%

1.60% 1.52% 1.5% 1.0% 1.18%

1.0% 0.88% 0.5%

0.5% 0.0%

-0.5% 0.0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13E 15E

Total Loans* Consumer Loans Total PCL as % of Loans *based on total PCLs Residential Mortgage Business & Gov't

Total Big Six Banks. Prior to 1987, the banks used a rolling five-year average to estimate loan losses. Source: Company reports, RBC Capital Markets estimates

Credit risk varies by loan type Canadian banks typically segregate loans into three broad categories: mortgages, consumer loans, and business and government loans. The three loan categories have different credit risk profiles. We believe that the Big Six Banks’ underwriting practices are similar for mortgages, and that the risk profiles of the six banks are fairly similar in that area. The risk profile of consumer loans and business loans, however, is likely to be less homogenous. A bank that has more credit cards as part of its consumer lending portfolio would have more credit risk (which is compensated for with higher spreads); a bank that has mostly secured lines of credit as opposed to unsecured lines would have less credit risk; and a corporate lender focused mostly on investment-grade clients would have less risk than one with a higher proportion of loans extended to non-investment grade clients.

The timing of loan losses in a recession also varies by loan type and within loan types. In retail lending, credit card loans tend to see defaults earliest, followed by loans backed by automobiles, followed by residential mortgages. Within business lending, commercial real estate exposures tend to default last.

 Generally, consumer loan losses will lead business loan losses, which can be partly explained as follows: businesses that are struggling will usually lay employees off before defaulting on loans. Laid-off employees therefore will likely default on some of their loans before businesses. Furthermore, there are many instances of struggling businesses refinancing their bank debt in secondary markets (or raising equity)—sources of capital that are not available to individuals.  In the 2008–2010 credit cycle, consumer loan losses were high, but an increase in business loan losses (other than commercial real estate) did not follow, as we believe that business loss rates were helped by a less levered business sector in Canada as well as lower single-name limits. Furthermore, many businesses were able to tighten their belts and make it through the most recent recession without many bankruptcies. The recession hit the US economy earlier, so Canadian companies had time to prepare, in our view, and many larger corporations facing financial difficulties were able to tap secondary markets to raise capital. In addition, the business sectors (or companies) that faced the most difficulties were those that had been facing challenges for years (auto, paper and forest, and manufacturing), so the banks did not have large exposures or the exposures were well collateralized. September 18, 2013 141 Canadian Bank Primer, Sixth Edition

Mortgages have the least credit risk Residential mortgages comprise the majority of household debt (approximately 67%, which rises to nearly 78% if including home equity lines of credit), and they are the lowest risk loans held on the Canadian banks’ balance sheets. In the last 20 years, the Canadian banks have lost an average of three basis points per year on mortgage loans. Perhaps most interesting is the banks’ experience in the early-to-mid 1990s, when the Canadian residential real estate market was weak, and unemployment and interest rates were high. The worst year that any of the six banks had in terms of losses was 11 basis points (Scotiabank in 1996). These loss rates are significantly lower than US loss rates, even if excluding the sub-prime market in the US. We discuss differences between the Canadian and US residential mortgage markets in “Section 11: Key differences compared to US banks”.

We expect loss rates for mortgages to remain small and well below other types of loans. Positive employment trends, conservative underwriting practices, mortgage insurance, and solid past appreciation in Canadian housing prices support our view. We provide a summary of our views below and expand on these themes further in the section that follows.

 Recent loss rates in Canadian mortgages on the banks’ balance sheets have been around 4–5 basis points. As we stated, the worst year a Canadian bank had in terms of mortgage losses in the 1990s was 11 basis points (Scotiabank), despite national housing prices declining in some of those years (Exhibit 114).  Canadian employment growth has been positive since the recession ended and interest rates are low, making mortgages affordable. The full recourse nature of most of the loans makes it unlikely that consumers will default on their mortgages in the context of employment being strong.  The LTV requirement of 80% for new uninsured mortgages provides a cushion against declining house values in case there were defaults while a large portion of mortgages are insured. About 65% of Canadian banks’ mortgages are insured, and average LTVs on uninsured mortgages are approximately 55%.

With Canadian prices having been so strong, we have received an increased amount of questions on what would happen if Canadian real estate prices declined. We believe that a decline in housing prices is possible (and has already occurred in Vancouver, where prices are down 5% from peak levels), but a very draconian scenario would be needed before Canadian banks would experience noticeable losses in their residential mortgage portfolios (Exhibit 115).

September 18, 2013 142 Canadian Bank Primer, Sixth Edition

Exhibit 115: Canadian house prices saw positive growth from 1999 to 2007, and since 2009; prices near or at peaks

Existing home sales price (YoY % chg) Price Index Existing Home Price Index (Since 1981) Jan-88 = 100 30% 600 25%

20% 500

15% 400 10%

5% 300 0%

-5% 200

-10% 100 -15%

-20% 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 0 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada U.S. Canada BC Alberta Ontario Québec

As of July 31, 2013. Source: National Association of Realtors, Canadian Real Estate Association, RBC Economics, RBC Capital Markets

Our caution on housing prices stems from weakening affordability on a national basis, particularly in British Columbia. Affordability metrics32 are near all-time lows in Vancouver while they are near the bottom end of the normal historical range for many parts of the country including Toronto (Exhibit 116). Furthermore, assuming constant housing prices, affordability will deteriorate if mortgage rates rise substantially from their current historical lows and household incomes increase only modestly. If one assumes a 200 basis point increase in mortgage rates, and a 6% increase in household income in the next two years, the affordability ratio for a typical bungalow would deteriorate to 47% from 43% today, which would be the worst level since 1990.

Exhibit 116: Canadian housing affordability at the high end of “normal”

Housing Affordability (Since 1985) 100%

90%

80%

70%

60% bungalow 50%

40%

tax income required to serviceto requiredmortgage adetached income fortax -

30%

20%

% of of median pre % 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada Toronto and area Montréal and area Vancouver Calgary

As of July 31, 2013. Source: Haver, RBC Economics, RBC Capital Markets

32 RBC Economics’ Housing Affordability Measures show the proportion of median pre-tax household income required to service the cost of mortgage payments (principal and interest), property taxes, and utilities on a detached bungalow, a standard two-storey home, and a standard condo (excluding maintenance fees). The measures are based on a 25% down payment, a 25-year mortgage loan at a five-year fixed rate, and are estimated on a quarterly basis. September 18, 2013 143 Canadian Bank Primer, Sixth Edition

Our comfort with banks’ residential mortgage portfolios, even if housing prices were to decline, stems from the following: mortgage lending was not predicated on permanently rising housing markets. US mortgage lending (especially sub prime) only worked in rising housing markets as income and recourse were afterthoughts. When housing prices declined, it immediately triggered defaults as many mortgage holders could not afford payments, and their only way out was refinancing their mortgage, which stopped working when house prices declined and underwriters for the high risk segment of the market disappeared. Unlike in the US, housing prices were frequently down in Canada during the 1990s, without a noticeable effect on either delinquencies or provisions for credit losses (Exhibit 120). The reasons are as follows:

 With very few exceptions, residential mortgage borrowers must pass a debt servicing test when obtaining a mortgage. Traditionally, borrowers’ mortgage payments must be 32% or less of income. The end result is that mortgage borrowers can afford their mortgage when they obtain it, and banks, with very few exceptions, are operating in the prime segment of the market.  Canadian banks operate in a friendly lender-recourse environment because personal loan covenants make it less attractive to default on a mortgage than many states in the US (with the exception of Alberta for low LTV mortgages). Having full recourse makes it very unlikely that an individual will default on a mortgage only based on house price depreciation, such as can be the case in many US states. Delinquencies tend to be driven by changes in employment situations (as well as marital breakdowns), not changes in house prices (or interest rates for that matter).  Uninsured mortgages originated by banks can only be underwritten with an LTV of 80% or less, thereby protecting the banks in case of default. Since house prices have been on a rising trend in Canada, the average LTV of their uninsured mortgage books is much lower (approximately 55% as shown in Exhibit 117). Uninsured mortgages are generally underwritten to hold, thereby increasing banks’ willingness to underwrite appropriately and conservatively, which has led to banks underwriting mortgages almost entirely based on both property value and debt servicing capacity. The US sub-prime mortgage market was a property-based market with looser lending standards.  Mortgages originated by lenders regulated by the Bank Act (e.g., banks and trust companies) with an LTV greater than 80% require mortgage insurance, which protects the mortgage lender for the entire mortgage principal amount during the life of the mortgage. Close to 60% of the mortgages on bank balance sheets are insured (Exhibit 117).

Exhibit 117: Insured mortgages represent about 60% of total mortgages on the balance sheet

Total Mortgages Domestic Only ( 1 ) Domestic Uninsured ( 1 )

Jan-96 Jun-13 Jul-13 Jul-13 % Insured % Uninsured % Insured % Uninsured % Insured % Uninsured Loan-to-value BMO 25% 75% 54% 46% 59% 41% 59% BNS 37% 63% 51% 49% 56% 44% 56% CM 35% 65% 71% 29% 72% 28% 54% NA 40% 60% 67% 33% 67% 33% 55% RY 30% 70% 46% 54% 43% 57% 47% TD 38% 62% 68% 32% 65% 35% 52% Median 36% 64% 61% 39% 62% 38% 55% Total 33% 67% 58% 42% 59% 41%

1 Based on Q3/13 company disclosures; Based on OSFI data as at June 30, 2013, we estimate that 62% of the domestic residential mortgage portfolio is insured. Source: Company reports, OSFI, RBC Capital Markets

September 18, 2013 144 Canadian Bank Primer, Sixth Edition

 For a bank to incur a loss on a residential mortgage, a customer first needs to default on an uninsured mortgage (a default on an insured mortgage does not lead to losses for banks), which normally happens in instances of job losses, and the decline in the value of the house must be at least 20% and in reality usually more than that before banks incur losses. We do not mean to imply that if housing prices declined 20% this would be a non-event for Canadian banks (employment in construction-related sectors, particularly condos, would suffer, condo developers would likely be challenged, and customer confidence would likely be weak, which would affect retail loan growth and consumer sectors, etc.), but we would not expect material losses in residential mortgage books. We discuss the size of construction exposures in the business loan sections.  For a more detailed discussion on the Canadian housing market, we direct readers to RBC Economics’ report Housing Trends and Affordability, published May 2013, and our colleague Geoffrey Kwan’s report Canadian Mortgage Primer, 4th Edition: Outlook and overview of the Canadian mortgage market, published April 17, 2013.

Exhibit 118: Residential construction as a % of GDP was larger in the US until 2008-2009

New Residential Construction as a % of Nominal GDP

7.0%

6.0%

5.0%

4.0%

3.0%

2.0%

1.0%

0.0% 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canada U.S.

Source: RBC Economics, RBC Capital Markets

Exhibit 119: Residential construction is important for employment

% of Employment within Construction

8.0%

7.5%

7.0%

6.5%

6.0%

5.5%

5.0%

4.5%

4.0%

3.5%

3.0% 0 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Canada United States Canada* * Construction emplyment excluding heavy and civil engineering construction. Shaded area represents a recession

Source: RBC Economics, RBC Capital Markets

September 18, 2013 145 Canadian Bank Primer, Sixth Edition

Exhibit 120: Canadian mortgage delinquencies have trended down

Canadian Mortgage Delinquencies (Since 1990)

1.2%

1.0%

0.8%

0.6%

Arrears Rate (> 90 days) 90 (>Arrears Rate 0.4%

0.2%

0.0% 90 92 94 96 98 00 02 04 06 08 10 12

Canada Ontario Quebec British Columbia Alberta

Source: Company reports, Haver, RBC Economics, RBC Capital Markets

Consumer loans have more credit risk than mortgages Consumer lending, on average, has had higher loss rates than business lending but with less volatility in the last two decades. The higher loss rates are primarily reflective of the banks’ credit card portfolios, which have higher loss rates than other consumer portfolios. Average loss rates for consumer loans of 106 basis points since 1990 include higher loss rates for credit cards (300–400 basis points in normal years, depending on the bank). If excluding the credit card portfolios, loss rates for consumer loans would be lower and more in line with business loans, with low loss rates on HELOCs helping support low aggregate loss rates. 33(Exhibit 121 and Exhibit 122).

Consumer lending is a catch-all for non-mortgage lending to individuals and small businesses. It includes unsecured lines of credit, home equity lines of credit, credit cards, car loans, term loans, and investment and RRSP loans. The largest components are, according to Investor Economics, instalment loans, credit cards, and personal lines of credit.

33 The HELOC market in Canada has not been used as aggressively as it was in some instances in the US. We believe that banks’ HELOC customers that also have a mortgage overwhelmingly (90%+) have the mortgage and the HELOC with the same institution. Also, banks are subject to the 80% LTV constraint for uninsured real estate secured credit, which includes credit related to HELOCs, and OSFI is now requiring a 65% LTV cap on non-amortizing HELOCs. To be clear, it would still be acceptable to have a combination of a mortgage and HELOC to aggregate to 80% LTV, but a stand-alone HELOC would be limited to 65% LTV. September 18, 2013 146 Canadian Bank Primer, Sixth Edition

Exhibit 121: Credit card losses can vary from bank to bank and are declining

Credit Card Provisions as % of Credit Card Loans (Since 2004)

7.0%

5.5%

NA BMO 4.0% CM TD

RY 2.5%

1.0% 04 05 06 07 08 09 10 11 12 13

BMO CM NA RY TD

We estimate BNS’s credit card loss rate at 2.6% in Q3/13. Source: Company reports, RBC Capital Markets

For consumer loans, we believe that the most important leading indicators of credit stress are employment growth and the change in the employment rate. People without jobs and who have no income usually have limited means with which to repay their loans other than with accumulated savings. When unemployment rises (and the rate of employment growth is what is important as opposed to the level of unemployment), retail loan losses would be expected to rise. Canada witnessed rapid job creation coming out of the recession, and has seen positive job gains in each year since 2009.

 Employment gains have improved in the Canadian economy with approximately 72,000 jobs created in the last six months ended August 2013, and 174,000 jobs in the prior six months. Canada’s unemployment rate has improved after deteriorating in late 2011. Since November 2012, the unemployment rate has remained in a tight range of 7.0– 7.2%, and currently stands at 7.1% in August 2013. RBC Economics expects the unemployment rate will nudge lower to 6.7% by the end of 2014. (Exhibit 123)

Exhibit 122: Consumer loan loss rates would be lower if they excluded credit cards

2012 Consumer loan loss rates BMO BNS CM NA RY TD Median Consumer PCL rate 1.1% 1.3% 1.9% 0.5% 0.9% 0.8% 1.0% Credit card PCL rate 4.5% N/A 4.5% 4.1% 3.0% 2.9% 4.1% Consumer (excl. credit card) PCL rate 0.6% N/A 0.8% 0.2% 0.5% 0.6% 0.6%

Source: Company reports, Statistics Canada, RBC Capital Markets

September 18, 2013 147 Canadian Bank Primer, Sixth Edition

Exhibit 123: Employment growth negatively correlated with consumer loan losses; unemployment rate stable recently

Employment vs. Consumer PCL Unemployment Rates (Annual since 1990) (Since 1976) Correlation Coefficient: -0.66 1.7% (3.0%) 15%

1.5% (2.0%) 13%

1.3% (1.0%) 11%

1.1% 0.0% 9%

0.9% 1.0% 7%

0.7% 2.0% 5%

0.5% 3.0% 3% 90 93 96 99 02 05 08 11 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Canadian banks: Consumer PCL Ratio (LHS) Change in Employment YoY in Canada (RHS inverted) Canadian Unemployment Rate U.S. Unemployment rate

Source: Company reports, Statistics Canada, RBC Economics, RBC Capital Markets

The other metrics worth paying attention to are income growth and interest rates. An increase in income is positive for debt-servicing ratios, while a decline in interest rates also helps. We do not believe, however, that the negative effect on credit quality of higher interest rates is as harmful as the income shock that results from losing a job, partly because a large portion of consumer debt is fixed rate (e.g., over two-thirds of mortgages in Canada are fixed rate).

Employment growth speaks to the likelihood of higher or lower loan losses. Other factors need to be considered in assessing the potential magnitude of losses.

 We believe that banks have moved up the risk curve in consumer lending since the early 1990s but are getting better “prices”. Banks have spent hundreds of millions of dollars on improving credit scoring and underwriting procedures, unemployment rates have declined, interest rates have declined, household liquidity has improved, and income levels have risen. So why have loss rates not declined since 1993? Additional leverage is one possible explanation, but we believe that banks have also increased their willingness to accept clients that they would have turned away under blunter credit granting systems. We think that it is a positive for the industry to “price better”, i.e., take on riskier businesses and prices for it via higher interest rates (in consumer lending, this relates primarily to credit cards), but when one thinks of peak loss rates, they should be higher in future credit cycles, in our view.  While the banks’ increased exposure to credit cards is leading to higher loss rates in consumer lending, the consumer loan books are better positioned than before when taking into account margins because the high yields on credit cards more than offset the higher loss rates while, outside credit cards, banks have reduced their exposure to unsecured consumer lending while growing secured lending (particularly home equity lines of credit or HELOCs, which have grown to about one-third in the last 10 years from about 12% of non-mortgage personal debt according to Investor Economics).  Compared to the early 1990s, we also believe that a greater proportion of personal loans are via lines of credit (many of which would be secured) rather than term loans. This shift might prove negative to loan loss rates in future years because some individuals that lose their income might now have sources of credit that were not available in the early 1990s and, as such, might have higher debt balances upon declaring personal bankruptcy. On the other hand, the availability of lines of credit might

September 18, 2013 148 Canadian Bank Primer, Sixth Edition

lead to lower loans losses for individuals who lose their job and then find jobs rapidly because they will have credit availability to bridge the gap in income.  The average Canadian consumer has increased their leverage in the last two decades, as highlighted earlier in this section (Exhibit 112).

Business loan losses have been most volatile historically Business lending has had the most volatile losses in the last two decades compared to consumer and mortgages. Average loan losses of 75 basis points have been 31 basis points lower than consumer loans, but the volatility in losses was higher in that period with higher peaks and lower troughs.

Banks have undertaken numerous efforts to reduce their exposure to business lending (Less than 30% of loans today compared to 54% in 1990) and to reduce concentration in certain industries or individual borrowers (Exhibit 131). They also have access to more secondary market options to manage risk (for example, loan sales and syndication, and credit default swaps).

We expect the volatility in business loan losses to continue because economic cycles will continue, and there are aspects of credit cycles that we expect will repeat in time, no matter how sophisticated the banks have become, but they may manifest differently. In a strong economy, it is human nature to feel more confident, particularly if a bank has built up a capital cushion in good times. This behaviour has repeated in different forms in the past, usually through the easing of underwriting standards in good times, and it will continue to lead to cyclicality in the banking industry’s loan losses, in our view.

When business credit losses occur, banks often provision more than is ultimately required because, in our view: 1) recovery rates are underestimated because asset values often improve by the time a loan is worked out (in times of credit stress, asset values are typically lower); 2) banks have an incentive to provision aggressively since they receive most of the tax deduction at that time (as opposed to when the loan is written off)34; and 3) when credit becomes bad, most investors likely expect large losses and may not differentiate much between a $1 billion or $1.5 billion provision (whereas, in a normal year, a bank expected to earn $1.5 billion would not see its stock perform well if it delivered earnings of $1.0 billion).

34 That statement is true in Canada but not in the US, where banks receive a tax benefit when charging off loans. September 18, 2013 149 Canadian Bank Primer, Sixth Edition

Exhibit 124: Business loans have declined as a percentage of total loans

Loan Mix (Annual since 1983)

80%

70%

60%

50%

40%

30%

20%

10%

0% 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Total Retail Loans as % Total Loans Mortgages as % Total Loans

Retail Non Mtg as % Total Loans Business and Government Loans

Total Big Six Banks. Mortgage mix grew in 2011 under IFRS. Source: Company reports, RBC Capital Markets

We track the following metrics to predict direction of business loan losses:

 Tightening in credit availability has been a useful predictor of loan losses in the past based on US senior loan officers’ surveys (this reflects banks’ expectations of rising losses on existing loans, although it could also represent caution from a capital perspective). Canadian data on credit conditions are not available for as long a time period but have tracked the US data in a similar fashion for the period that is available (Exhibit 125).  Business loan losses have generally followed the rise of rating agency downgrades compared to upgrades (Exhibit 125). Loan losses are inversely correlated with the strength of rating agency ratings.  The health of businesses is also a good leading indicator of business loan losses. We focus on corporate earnings growth as well as employment growth to obtain a sense of the health of businesses. In a weakening economy, more businesses struggle to pay their bills; however, it can take a while before a company stops being current on its debt, depending on the speed at which profitability deteriorates its leverage and cash reserves (Exhibit 126).  Credit spreads on corporate bonds. Credit spreads reflect, in large part, capital markets’ view of risk for fixed income securities; if credit spreads are rising, then capital markets are normally telling us that credit risk is increasing, which normally occurs before losses. The drawback of using credit spreads, however, is that liquidity risk and credit risk both play a role in the spread levels and, as such, volatility in spreads is likely to be higher than volatility in underlying credit quality. Furthermore, bank loans often rank senior to publicly traded debt and, as such, should benefit from higher recovery rates in case of default (Exhibit 127).  Equity market volatility can also be used to predict business loan losses. (Exhibit 127)

September 18, 2013 150 Canadian Bank Primer, Sixth Edition

The above metrics, which we use to forecast whether business loan losses will rise or decline, all point toward a stable outlook.

Exhibit 125: Business loan losses follow a credit tightening cycle and rise when ratings downgrades outpace upgrades

Senior Loan Officer Survey vs. Business & Gov't PCL (Annual since 1990) Rating Agency Downgrades/Upgrades vs. Business and Gov't PCL ratio (Annual since 1998) Correlation Coefficient: 0.62 * Correlation Coefficient: 0.45 * 100% 3.0% 10.0x 3.0%

80% 2.5%

8.0x 60% 2.0% 2.0%

40% 1.5% 6.0x 20% 1.0% 1.0% 0% 4.0x

0.5% -20% 0.0% 2.0x -40% 0.0%

-60% -0.5% 0.0x -1.0% 90 91 93 94 96 97 99 00 02 03 05 06 08 09 11 12 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 US Senior Loan Officer: Tightening Standards For C&I Loans (Large & Medium Businesses) (%) (LS) Canada Senior Loan Officer: Tightening Lending Conditions (%) (LS) Down-Up Ratio Business & Gov't PCL (RHS) Canadian banks: Business & Gov't loan losses (RS)

* Downgrades to upgrades in the Canada and the US by Moody’s, S&P, DBRS. Source: Company reports, Federal Reserve Board, Bloomberg, Statistics Canada, RBC Economics, RBC Capital Markets

Exhibit 126: Business loan losses tend to increase as corporate earnings growth or Canadian employment decline

TSX Earnings Growth vs. Business & Gov't PCL Employment vs. Business and Gov't PCL (Annual since 1990) (Annual since 1990) Correlation Coefficient: -0.44 * Correlation Coefficient: -0.47 * 3.0% -60% 2.5% (3.0%)

2.0% (2.0%)

2.0%

-20% 1.5% (1.0%)

1.0% 1.0% 0.0%

20% 0.5% 1.0%

0.0%

0.0% 2.0%

-1.0% 60% -0.5% 3.0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 90 93 96 99 02 05 08 11

Canadian banks' Business & Gov't PCL ratio (LHS) TSX Earnings Growth (RHS inverted) Canadian banks' Business & Gov't PCL ratio (LHS) Change in Employment YoY in Canada (RHS inverted)

*Business and government PCL lagged one year for correlation Source: Company reports, Bloomberg, Statistics Canada, RBC Economics, RBC Capital Markets

September 18, 2013 151 Canadian Bank Primer, Sixth Edition

Exhibit 127: Business loan losses often follow changes in corporate bond spreads and expected equity market volatility

Corporate Bond Spreads vs. Business & Gov't PCL VIX Volatility Index vs. Business & Gov't PCL (Annual since 1990) (Annual since 1999) Correlation Coefficient: 0.17 bps Correlation Coefficient: 0.32 * 3.0% 500 3.0% 100%

2.0% 375 2.0% 50%

1.0% 250 1.0% 0%

0.0% 125 0.0% -50%

-1.0% - -1.0% -100% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Canadian banks' Business & Gov't PCL ratio (LHS) VIX Index YoY change (RHS) Canadian banks' Business & Gov't PCL ratio (LHS) Corporate Bond Spreads (U.S.) (RHS)

US Corporate Bond Spread = BAA minus 10-year Treasury bond. VIX: CBOE Volatility Index. Source: Company reports, Bloomberg, RBC Capital Markets

The metrics highlighted above are useful in determining whether there will be more or fewer businesses that may default, but more work needs to be done in predicting loan losses. As highlighted earlier, Canadian businesses have seen significant improvements in leverage (measured both by debt-servicing burden and by balance sheet leverage), which in theory should make them less sensitive to changes in macro conditions than in the past.

 The risk behind this statement is that it is based on average metrics for a country. Within an average, there are outliers. If a sector of the economy holds high leverage or if certain companies are allowed to lever their balance sheets aggressively, the “average” might miss the tail.  Banks that focus on higher risk loan categories (i.e., leveraged loans) will be more affected by a business credit cycle. That disclosure has historically not been available, although this is changing. Basel II disclosures provide some insights, but the data history is brief, and there are comparability issues between banks.  Changes in mix can also have an effect on losses borne by banks. If a bank makes an effort to change its loan mix between investment-grade clients and non-investment grade clients, this will have an effect on loss rates. Scotiabank, CIBC, and TD were particularly aggressive at reducing non-investment grade corporate exposures following the early-2000s credit cycle, which helped those three banks in the most recent recession.  Credit events can be industry-specific and not necessarily indicative of broad deterioration in the economy or corporate sector health overall. Credit events can also be specific to certain geographies.  We also believe that when bankruptcies occur in long-struggling sectors (in Canada, the paper and forest and automobile sectors stood out in the most recent recession), banks typically will not lose material amounts because the lending will have been done on a highly cautious basis. Losses tend to be more severe when an industry or company goes from being perceived as strong to weak in short order. The most recent recession caused lower business loan losses than in the early 1990s. We believe that loss rates were helped by a less levered business sector in Canada as well as lower single-name limits. Furthermore, many businesses were able to tighten their belts and make it through the last recession without many bankruptcies given that it hit the US economy before Canada’s economy, so companies had time to prepare, and many larger

September 18, 2013 152 Canadian Bank Primer, Sixth Edition

corporations facing financial difficulties were able to tap secondary markets to raise capital. In addition, the business sectors (or companies) that have faced difficulties were those that had been facing challenges for years (auto, paper and forest, and manufacturing), and as such the banks do not have large exposures, or the exposures are well collateralized.

The area of business credit that bears watching, in our view, is exposure to Canadian condo construction. We believe that condo construction would be the first area to be negatively impacted by a pullback in house prices in Canada, as it would likely cause decreased demand for new condos and potentially credit problems related to unfinished projects. We view this as a risk for 2014/2015 rather than 2013, but would point out that the exposures are not that large for the banks, with the largest exposure among the Big Six banks amounting to less than 0.4% of loans.

Exhibit 128: Canadian condo exposures are a concern, but banks’ exposures are small relative to total loans and equity

Canadian high-rise condo construction exposure Drawn % of % of % of $ billions Business Loans Total Loans CET1 Notes BMO 0.8 0.8% 0.3% 3.9% Mostly Toronto and Vancouver BNS 0.8 0.7% 0.2% 3.3% CM 0.9 2.0% 0.4% 7.4% $2.0 billion undrawn exposure NA 0.1 0.6% 0.2% 2.7% 60% Quebec based, Ontario second largest RY 1.1 1.3% 0.3% 7.4% $1.14 billion high-rise, $0.23 billion low-rise (6 stories or less). $2.0 billion high-rise undrawn. TD 0.9 0.8% 0.2% 3.7% Source: Company reports, Bloomberg, RBC Capital Markets

Key credit ratios to monitor and accounting treatment The previous sections discussed important macro indicators to track in determining the direction of future loan losses. Before we discuss how to use available disclosures to predict loan losses, we discuss key credit ratios to monitor, provide a definition of the different items, and examine the accounting for credit-related items in this section.

Canadian banks adopted IFRS in 2012, which led to changes to loan loss provisioning terminology and descriptions that are not consistent across the banks. Generally, but not in all instances, what used to be called specific provisions for credit losses is now called provisions for individually significant loans and for individually insignificant and collectively assessed loans. General provisions are now called, by most banks, collectively assessed provisions for not yet identified as impaired loans.

The gross impaired loan (GIL) ratio measures the percentage of total loans that are impaired. Loans are classified as impaired when the bank no longer has reasonable assurance of timely collection of the full amount of principal and interest.

 New impaired loan formations increase the GIL balance.  Impaired loans are eventually sold, recovered, or written off if a bank does not expect to recover amounts lent. A write-off would reduce the GIL balance, as would impaired loans that are repaid and returned to performing status when the bank can reasonably expect future collection of principal and interest again.

Impaired loan formations represent the increase in GILs and are offset by impaired loans that are repaid and returned to performing status.

The net impaired loans ratio measures the size of impaired loans after specific and general allowances, expressed as a percentage of total loans. This measure is popular but in our view

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it is misleading because it considers allowances meant for performing loans (general allowances) as allowances available to cover GILs when they are not.

Allowances for credit losses can be for:

 Impaired loans specific to a single counterparty, i.e., how much of an impaired loan, which is individually significant such as a corporate loan, that a bank expects to write off in the future.  Impaired loans that are individually insignificant and collectively assessed on a portfolio of smaller loans, i.e., how much a bank expects to write off in the future for a portfolio of impaired loans that are not individually significant, such as smaller personal loans.  Collectively assessed loans that are not yet identified as impaired, i.e., how much a bank has set aside to cover losses that are expected to occur in the future but where loans are still performing.  We believe that analysts should look at allowances relative to GILs, as well as allowances in the context of the size of total loan books and the risk of loan books. Excluding residential mortgages given their low historical loss rates is probably a valid exercise.

The provision for credit loss ratio measures the effect on the income statement of increasing or decreasing allowances for credit losses.

Accounting for credit-related items Banks originate loans and record them at amortized cost.35 Managements regularly review the loan portfolios to assess potential impairment status. OSFI expects a loan to be classified as impaired when the bank no longer has reasonable assurance of timely collection of the full amount of principal and interest on the loan. In our view, the classification of a loan as impaired is both art and science:

 Loans are generally classified as impaired when payment is 90 days past due, unless the loan is secured and management reasonably expects repayment within 180 days past due.  Credit card loans are written off after payment is 180 days in arrears.  Insured mortgages or other loans guaranteed by the Canadian government are impaired when the loan is contractually 365 days in arrears.  On loan portfolios that are not individually significant, impairments are classified using current and historical credit information in both quantitative and qualitative assessments.  Larger loans can be classified as impaired ahead of events that would automatically trigger impairment36 if the bank has a high degree of certainty that it will not be able to collect the principal and interest due.

Once a loan is classified as impaired, it is carried on the balance sheet at an estimated realizable value and interest stops accruing. The value is based on expected future cash flows including collateral considerations discounted by a rate inherent on the loan.

35 Historically, banks had an option to designate assets as held for trading when first acquired and carried at fair value, as long as it satisfied certain criteria established by OSFI. However, upon adoption of IFRS in 2012, banks were required to apply IAS 39 and classify financial instruments as of the original acquisition date, or banks could designate a previously recognized financial asset or financial liability as a financial asset or financial liability as at FVTPL or a financial asset as AFS on transition to IFRS. 36 A missed interest and principal payment or if a company goes into bankruptcy court protection, for example. September 18, 2013 154 Canadian Bank Primer, Sixth Edition

 New impaired loans increase the GIL balance and are offset by impaired loans that are repaid and returned to performing status when the bank is reasonably assured of future collection of principal and interest again, or written off.  GILs reflect loans that are facing difficulty, and the GIL ratio measures the percentage of total loans that are impaired.

Establishing allowances for impaired loans Once a loan has become impaired, a bank establishes and maintains an allowance for credit losses on its balance sheet that reflects how much of its loan portfolio, both impaired loans and not yet identified as impaired, that it expects to write off in the future and is netted against gross loans on the balance sheet. An impaired loan is usually not worth zero because it probably has collateral attached to it, so a bank may recover all or part of the amount loaned to a customer by seizing the collateralized asset and selling it.

 Allowances for individually significant loans such as corporate loans are determined on a loan-by-loan basis to reflect the estimated credit loss, while collectively assessed allowances are calculated on a pooled basis using write-off experience. Collectively assessed allowances are typically for retail loans such as mortgages and personal loans.  A bank increases its allowance for credit losses for individually significant and insignificant impaired loans by a charge to the income statement, called a specific provision for credit losses, and decreases it by writing off the loans, net of any recoveries.  The allowance for credit losses can be low, as would be the case for residential mortgages, which have high recovery values, or high in instances where banks do not believe that they will recover much from the impaired loans. The adequacy of allowances depends on the bank and its business mix. For example, a bank with a track record of low loan losses and high exposure to mortgages or secured loans could justify a low allowance relative to impaired loans.

Banks also maintain a collectively assessed allowance for credit losses that is used to cover credit losses that managements estimate will occur in the future yet have not been specifically identified as impaired. A certain level of loss is expected in each portfolio based on historical loss rates and probability of default. The calculation also considers current credit-quality trends and business and economic conditions, and can include a safety buffer that helps capture inaccuracies in risk models and methodologies.

 A bank increases its collectively assessed allowance for loans not yet identified as impaired by a charge to the income statement, which is sometimes called a collective provision for not yet impaired credit losses, or decreases the allowance by reversing the provision when it believes it is more than adequately reserved.  Additions and removals to reserve balances are often ignored by analysts because impaired loans need a specific allowance against them. In other words, this collective allowance for not yet impaired loans cannot be used once loans are classified as impaired, so having a higher allowance does not necessarily mean that a bank is better provisioned to handle future impairments. We, however, view changes to these reserves as a real cost of doing business and as a useful indicator of banks’ views on upcoming credit losses. Unless increases in the collective allowance for not yet impaired loans are driven by acquisitions or portfolio growth, a bank may be implying a higher expected individually significant or non-significant loan losses by raising its collectively assessed allowance for not yet impaired loans, in our view.  The difference between GILs and the allowances for impaired loans represents net- impaired loans (NILs). A bank with a larger negative NIL balance is considered better

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reserved given that allowances more than cover impaired loans. It is also conservative, in our view, to have larger allowances relative to GILs, although a bank with a track record of low loan losses and high exposure to mortgages or secured loans could justify a low allowance relative to impaired loans.

Moving impaired loans off the balance sheet Impaired loans do not stay on the balance sheet permanently. Loans are eventually sold, recovered, or written off if banks do not expect to recover amounts lent.

 For credit cards, no “specific” allowance is maintained because balances are written off when a payment is 180 days in arrears. Personal loans are generally written off at 150 days past due. Write-offs for other loans are generally recorded when there is no realistic prospect of a full recovery.  A write-off would reduce the GIL balance as well as the allowance for credit losses. It has no effect on the income statement.  If a bank sells a loan for an amount greater than it had valued it, then it would reduce the allowance for credit losses by taking a negative provision for credit losses. In such an event, the income statement would benefit, and GILs, the allowance for credit losses, and NILs would be reduced.

Example of movements in impaired loans and allowances The accounting for credit losses can be confusing to those learning about banks, so we provide an example of the moving parts with numbers (Exhibit 129).

In our example, the bank has a beginning GIL balance of $2,000, against which it has established an allowance for an individually significant impaired loan of $700, implying a coverage ratio of 35%. The bank also has $1,500 in collectively assessed allowances for not yet impaired loans.

In year one, the bank has a client to whom it lent $800, who defaults on the loan and goes under bankruptcy protection. The bank classifies the $800 loan as impaired and has to establish an allowance that reflects expected losses net of recoveries (in this case $300). The income statement hit is $300, GILs rise by $800, and the allowance for individually significant impaired loans increases by $300.

In year two, the loan is still in default, but the bank sees the need to adjust its estimate of recoveries (downward in this case). GILs do not change, but the allowance for loan losses rises by $100, and the income statement hit is $100. The bank’s coverage ratio also increases because allowances also strengthened in the context of the size of the impaired loans.

In year three, the bankruptcy is resolved, and the bank is able to recover $450. The $450 recovery exceeds the bank’s estimate by $50; therefore, the bank is able to book a reversal of $50 in PCL, a positive effect on the income statement. The $800 GIL balance disappears, as do the allowances established against that loan. Had the recovery been exactly what the bank originally estimated, the income statement effect would have been zero.

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Exhibit 129: Example of movements in impaired loans and allowances

Year 0 Year 1 Year 2 Year 3

Gross impaired loans 2,000 2,800 2,800 2,000 Allowance for impaired loans 700 1,000 1,100 700 Collectively assessed allowance for not yet impaired 1,500 1,500 1,500 1,500 Net impaired loans (200) 300 200 (200)

Total coverage ratio 110% 89% 93% 110%

Impact of new formations and writeoffs on gross impaired loans New impaired loans 800 0 0 Writeoffs 0 0 (800) 800 0 (800)

Impact of new formations and writeoffs on income statement Provision for credit losses (specifically identified as impaired) (300) (100) 0 Recovery of provisions for credit losses 0 0 50 Pre-tax income statement impact (300) (100) 50

Impact of new formations and writeoffs on allowances (on balance sheet) Provision for credit losses (specifically identified as impaired) 300 100 0 Recovery of provisions for credit losses 0 0 (50) Allowances on loans being written off 0 0 (350) 300 100 (400)

Source: RBC Capital Markets

Accounting methodology for credit losses could change in medium term The accounting methodology used to determine loan losses and allowances could change in upcoming years, based on work undertaken by the International Accounting Standards Board. The work that has been undertaken is still at the proposal stage and it could take years before the rules are finalized and implemented. Directionally, the new accounting rules (1) could lead to higher provisions and allowances during “good” times, (2) earlier recognition of credit problems as loan quality deteriorates, (3) lower provisions for credit losses in “bad” times or in the period a loan actually becomes non-performing, and (4) the same ultimate allowance over the life of loan from origination until the point of impairment. Ultimate loan losses over the life of loans that become impaired should be the same under both methodologies, but they would likely be less lumpy under the proposed accounting rules.

Under the new proposed rules, banks would be required to hold higher allowances than is currently the case in “good” times as banks would be required to establish reserves even for loans that are not expected to incur losses in the next year. As a result, as new loans are originated, a provision for loan losses would need to be incurred to build the allowance. In a deteriorating environment where the quality of a loan would deteriorate (but not necessarily become non-performing), such as when an investment-grade company gets downgraded to non-investment grade, banks would increase allowances via provisions for credit losses under the new regime, whereas little happens under the current regime. If a loan went impaired, the allowance would have to be built up through provisions for credit losses if there was need for further buildup. Compared to existing rules, the build-up in allowance in the last period would be lower given a higher starting allowance (the ultimate allowance would be the same but the provisioning would be less lumpy in the last period as it the allowance would gradually increase through the life of the loan whereas, under current accounting system, the allowance is mostly established at impairment).

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How to use available disclosures Now that definitions are out of the way, a discussion on how to use bank disclosures is in order. Bank disclosures, while lacking in many important aspects, offer different ways to assess direction of loan losses. We believe the following indicators are important to track:

 Is the formation of impaired loans accelerating or slowing? When there are high levels of new impaired loans and low levels of collections and loans returned to performing status, banks typically record higher provisions in following quarters. The trend in formations is the most useful thing to watch, in our view (Exhibit 130).  The size of exposures to particular geographies. Banks with US exposures experienced faster increases in the early stages of the 2007–2009 economic slowdown, which affected the US before Canada. National Bank, with roughly two-thirds of its loan book in Quebec, was less affected by credit issues during that period because Quebec’s economy and unemployment rate did not deteriorate as much as the US, Ontario, BC, and Alberta—areas where the other banks have more exposure.  The size of exposures to troubled sectors. Banks provide disclosure by sector for corporate lending. Sector diversification is key because loan losses tend to hit banks in different sectors from cycle to cycle. Analysts should be cautious of banks that are overexposed to certain sectors, no matter how healthy the sector may appear in good times, and once certain sectors begin to weaken, one must quickly identify which banks are more or less exposed. The disclosure is, unfortunately, not always comparable, can lack in granularity and show exposures gross of credit default swap protection. The size of the “Other” category is an example of the lack of granularity because it can account for 15–30% of business and government loans for the banks (Exhibit 131).  Importantly, the size of exposures should be measured against capital (common equity or common equity Tier 1 capital). The reasoning behind this is that two banks might have a similar business mix, and both have, for example, 5% of their business loans in automobile loans. If a bank has half the exposure to business lending as the other, the comparison is not accurate. Sizing the exposures relative to capital eliminates that potential distortion.

Exhibit 130: Net impaired loan formations are a good predictor of provisions for credit losses

Net Impaired Loan Formations and Loan Loss Provisions (Annual since 1977) Correlation Coefficient: 0.61 3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%

-0.5% 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Net Formations (as % of Total Loans) Total Provisions (as % of Total Loans)

Total Big Six Banks. Source: Company reports, RBC Capital Markets

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Exhibit 131: Real estate and consumer goods are the largest business loan categories

Business & Government Loans (includes Commercial loans) BMO BNS CM NA RY TD Total As at Q3/13 Q3/13 Q3/13 Q3/13 Q3/13 Q3/13 Q3/13 Business & Government Loans and Acceptances ($MM) 109,896 128,800 56,809 36,278 96,064 116,260 544,107 As % of Total Loans & Acceptances 40% 31% 22% 41% 23% 26% 29% As % of Common Equity 401% 329% 354% 495% 225% 253% 305% As % of Common Equity Tier 1 Capital 533% 511% 455% 693% 331% 459% 461%

Business & Government portfolio mix Median Agriculture 5% 5% 7% 7% 6% 3% 5% Automotive (manufacturing, trade, services) 2% 6% n/a n/a 7% 3% 5% Consumer goods (retail, manufacturing) 12% 11% 10% 13% 6% 4% 10% Industrial products, manufacturing, trade, chemical 12% 1% 3% 9% 4% 7% 5% Energy, oil and gas 4% 9% 7% 12% 9% 2% 8% Financial institutions 17% 12% 6% 5% 5% 10% 8% Food & Beverage 1% 3% n/a n/a n/a 2% 2% Forest products 0% 1% 1% n/a 1% 1% 1% Mining and metals 1% 5% 2% n/a 1% 2% 2% Real estate, construction and related 21% 10% 34% 15% 24% 32% 23% Communications, technology, media 1% 3% 3% 4% 4% 2% 3% Transportation and environment 2% 6% 4% 3% 6% 4% 4% Utilities (Electric, gas, water) 1% 4% 4% n/a n/a 2% 3% Other (including services) 20% 21% 18% 31% 22% 18% 21% Government, sovereign 1% 3% 3% 1% 4% 7% 3% Total Business & Government Loans & Acceptances 100% 100% 100% 100% 100% 100%

As % of Common Equity Median Agriculture 22% 16% 24% 34% 13% 9% 19% Automotive (manufacturing, trade, services) 8% 19% n/a n/a 17% 9% 13% Consumer goods (retail, manufacturing) 47% 35% 36% 66% 14% 10% 36% Industrial products, manufacturing, trade, chemical 47% 4% 9% 44% 9% 17% 13% Energy, oil and gas 14% 30% 25% 60% 21% 6% 23% Financial institutions 66% 39% 23% 24% 12% 24% 24% Food & Beverage 5% 9% n/a n/a n/a 6% 6% Forest products 2% 4% 3% n/a 2% 2% 2% Mining and metals 3% 15% 6% n/a 2% 4% 4% Real estate, construction and related 86% 34% 119% 74% 55% 80% 77% Communications, technology, media 3% 12% 9% 19% 9% 6% 9% Transportation and environment 7% 20% 13% 15% 13% 11% 13% Utilities (Electric, gas, water) 5% 14% 14% n/a n/a 6% 10% Other (including services) 82% 69% 63% 152% 49% 44% 66% Government, sovereign 4% 10% 9% 7% 10% 18% 9% Total Business & Government Loans & Acceptances 401% 329% 354% 495% 225% 253% 342%

As % of Common Equity Tier 1 Capital Median Agriculture 29% 24% 31% 48% 18% 16% 26% Automotive (manufacturing, trade, services) 10% 30% n/a n/a 25% 16% 20% Consumer goods (retail, manufacturing) 63% 54% 47% 92% 21% 18% 50% Industrial products, manufacturing, trade, chemical 63% 6% 12% 62% 13% 32% 23% Energy, oil and gas 19% 46% 32% 83% 31% 11% 31% Financial institutions 88% 61% 29% 33% 17% 44% 38% Food & Beverage 7% 13% n/a n/a n/a 11% 11% Forest products 3% 6% 4% n/a 3% 4% 4% Mining and metals 4% 24% 8% n/a 4% 8% 8% Real estate, construction and related 114% 52% 153% 104% 81% 146% 109% Communications, technology, media 3% 18% 12% 27% 13% 10% 13% Transportation and environment 10% 32% 16% 21% 19% 20% 20% Utilities (Electric, gas, water) 7% 21% 18% n/a n/a 11% 15% Other (including services) 109% 108% 81% 212% 71% 81% 94% Government, sovereign 6% 16% 12% 10% 14% 32% 13% Total Business & Government Loans & Acceptances 533% 511% 455% 693% 331% 459% 485%

Source: Company reports, RBC Capital Markets

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The strength of reserves also needs to be assessed. We measure this in two different ways: 1) how large total reserves are in relation to historical loan losses (a useful calculation in good times); and 2) how large total reserves are relative to the size of impaired loans as well as total loan books excluding residential mortgages. These measures are not perfect, but they should help analysts formulate questions for management teams. For example:

 If total reserves are declining, or low relative to historical loan losses or to the size of the loan book, has the portfolio mix changed or will reserves be bulked up in a credit downturn? As Exhibit 134 shows, as of the third quarter of 2013, this would be most relevant for National Bank and Royal Bank, with credit reserves that are equivalent to 2.2 years of loan losses, respectively, based on historical losses compared to 4.5 years at Scotiabank.  Total allowances for credit losses for the industry are currently around 0.69% of loans, which is lower than the 1.9% peak in 2002 and 3.0% peak in early 1990s (Exhibit 133). Directionally, some of the decline would be explained by a decline in business lending exposures, which has been offset by an increase in residential mortgages that do not require similar reserves given a lower-risk profile. Business lending has declined to 27% from 54% of total loans in 1990, while mortgages increased to 46% from 28% in 1990.  Excluding mortgages, total allowances have declined since 2002, to 1.32% in the second quarter of 2013 from 3.2% (Exhibit 133). Total allowances include collective allowances for loans that have not yet been identified as impaired, which are meant to cover credit losses that managements estimate will occur in the future yet have not been specifically identified as impaired; therefore, allowance adequacy could be directionally judged in the context of the banks’ performing loan books, not the impaired segment of loan books. Collective allowances for loans that have not yet been identified as impaired should trend based on: 1) the size of banks’ loan books; 2) the mix of the loan books—riskier loan books should have higher collective allowances; and 3) the economic outlook—a more uncertain outlook should drive higher allowances. The industry has fewer reserves than in the past, which would partly reflect lower exposure to business lending and greater exposure to residential mortgages.  If GILs are rising faster than allowances for credit losses, is that happening because the newly impaired loans have high collateral, or do allowances need to “catch up” to the higher level of impaired loans via specific PCLs? Using an example under Canadian GAAP as an illustration, from the fourth quarter of 2007 to the second quarter of 2008, Bank of Montreal had a 65 basis point increase in GIL, but specific allowances as a percentage of impaired loans dropped to 17.9% from 21.8%. In the third quarter of 2008, PCL rose by $283 million from the prior quarter because the bank strengthened its allowances for loans classified as impaired between the fourth quarter of 2007 and the second quarter of 2008.  To get a sense of direction in PCL, we believe it is important to track how fast impaired loans are rising and also to try to understand whether the impaired loan mix has changed.  For the industry as a whole, total allowance for credit losses amount to 95% of impaired loans, which have declined from about 175% in 2006 (Exhibit 133).  Allowances relative to impaired loans vary dramatically between banks (68% to 164% among the Big Six banks, as shown in Exhibit 134), but we would be cautious in stating that banks with lower reserves necessarily are less well reserved. Allowances for credit losses are a function of how much is expected in recoveries on impaired loans; highly collateralized loans would have much higher recovery rates, so they would not need large allowances.

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Exhibit 132: Total loan loss allowances have declined since the early 1990s

Loan Loss Allowance Levels (Annual since 1985) 5.0%

4.0%

3.0%

2.0%

1.0%

0.0% 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Total Allowance as % of Loans

Total Big Six Banks. Loan-Loss Allowance includes specific and general allowance. Source: Company reports, RBC Capital Markets

Exhibit 133: Total allowance relative to loans and impaired loans is low

Total Allowance as % of Loans Total Allowance as % of Impaired loans (Annual since 1988) (Annual since 1988)

5.0% 200%

175% 4.0% 150%

3.0% 125%

100%

2.0% 75%

50% 1.0%

25%

0.0% 0% 88 90 92 94 96 98 00 02 04 06 08 10 12 88 90 92 94 96 98 00 02 04 06 08 10 12

Total Allowance as % of Loans Total Allowance as % of Loans (excl. Mortgages) Total Allowance as % of Gross impaired loans

Total Big Six Banks. Source: Company reports, RBC Capital Markets

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Exhibit 134: Key credit ratios

Summary Big Six banks Regional banks Q3/13 BMO BNS CM NA RY TD Total CWB LB

GILs (% of loans) 1.00% 0.92% 0.66% 0.43% 0.51% 0.61% 0.71% 0.47% 0.36% QoQ increase (in basis points) (11) 1 (3) 2 (4) 2 (2) 6 (7) YoY increase (in basis points) (15) (1) (6) 1 (5) 1 (4) 9 (13) Total Allowance (% of loans excl. mortgages) 1.09% 1.72% 1.90% 1.10% 1.02% 1.20% 1.31% 0.55% 0.93% Total Allowance vs Avg historical PCL (in years) 2.8 4.5 3.9 2.2 2.2 2.4 2.7 2.7 2.2 NILs (% of loans) 0.29% 0.10% (0.08)% (0.22)% 0.01% (0.09)% 0.02% (0.08)% (0.06)%

Impaired Loan Formations ($ millions) (229) 478 293 58 269 536 1,405 14 (11) QoQ increase (251%) 47% (6%) 287% (27%) 5% (17%) 45% (10521%) YoY increase (234%) 37% 34% 5700% (13%) 18% (7%) 587% (220%)

Total PCL (% of loans) 0.12% 0.31% 0.52% 0.22% 0.27% 0.45% 0.33% 0.20% 0.13% QoQ increase (in basis points) (11) (3) 9 (3) (3) 5 (1) 2 (0) YoY increase (in basis points) (17) (1) 9 7 (10) 8 (2) 2 1 Median historical PCL % of loans (current loan mix) * 0.39% 0.38% 0.48% 0.50% 0.45% 0.50% 0.49% 0.20% 0.42%

Total (allowance) coverage ratio (% of GILs) 70.9% 89.2% 112.3% 151.5% 97.1% 115.1% 96.7% 116.2% 116.2% QoQ increase (in basis points) 279 (165) 115 (1,212) 296 (41) 93 (1,281) 1,899 YoY increase (in basis points) 583 146 478 (560) 141 (115) 283 (2,087) 2,517

* Based on historical median PCL rates for residential mortgages, consumer, business, and government portfolios since 1990 (or 2000 for National Bank). Source: Company reports, RBC Capital Markets

Loss ratios compared to historical losses need to be tracked as well, in our view. We believe that looking at historical loss rates under different economic scenarios is useful in understanding where banks are in a credit cycle and estimating the potential effect of normalization in loan losses. For example, as Exhibit 135 shows, some banks had loan losses well above their historical averages in 2009, which in large part reflected business mix (i.e., more exposure to consumer lending, which underperformed other loss categories relative to historical averages), and the banks are currently below their historical averages. If credit normalized in all loan categories for all banks, the banks with higher losses as a percentage of historical losses could be more affected; nevertheless, it is not a perfect method.

 Loan mixes change and risk profiles also evolve within loan categories. For example, historical business loan losses for a portfolio that was 60% non-investment grade and is now 30% non-investment grade would suggest higher “normal” loan losses than what is likely to be the case in the future.  Banks have access to more sophisticated risk-measurement tools, and the development of more active secondary markets for loans and credit-default swaps have given banks the tools to better manage risk. There are three key caveats: 1) Are the tools actually being used? 2) Are the tools being used to target higher-risk customers and charging a higher price (not a bad practice but, nonetheless, one that leads to higher credit risk)? 3) Is there a risk that loans that were thought to have been sold to outside investors may come back to hurt the bank if, for example, the bank provided financing to that buyer?  There is also no such thing as “normal” losses. Banks usually lose less than the simple, historical-average, loan-loss rates, and in difficult times loss rates can exceed the normal rate. For example, the average loss rate for Canadian banks in the last 23 years was 57 basis points. In eleven of those years, loss rates were more than 10 basis points below the historical average, and in seven of those years, loss rates were at least 10 basis

September 18, 2013 162 Canadian Bank Primer, Sixth Edition

points higher than the historical average. Losses were, therefore, “normal” in only five of the last 23 years.

Exhibit 135: PCL rates relative to long-term averages can be useful in determining exposure to normalizing loan losses

Regional Banks PCL ratios BMO BNS CM NA RY TD Total CWB LB 2007 PCL % of loans 0.23% 0.12% 0.39% 0.22% 0.34% 0.38% 0.27% 0.15% 0.31% 2008 PCL % of loans 0.80% 0.24% 0.46% 0.29% 0.60% 0.54% 0.50% 0.15% 0.35% 2009 PCL % of loans 0.94% 0.62% 0.96% 0.34% 1.02% 1.04% 0.88% 0.15% 0.38% 2010 PCL % of loans 0.63% 0.45% 0.60% 0.26% 0.46% 0.62% 0.53% 0.21% 0.40% 2011 PCL % of loans 0.56% 0.35% 0.48% 0.26% 0.33% 0.41% 0.41% 0.19% 0.24% 2012 PCL % of loans 0.32% 0.37% 0.53% 0.23% 0.36% 0.45% 0.41% 0.19% 0.28% 2013E PCL % of loans 0.23% 0.34% 0.45% 0.21% N/A 0.41% 0.36% 0.19% 0.13% 2014E PCL % of loans 0.35% 0.35% 0.35% 0.22% N/A 0.46% 0.38% 0.19% 0.13% 2015E PCL % of loans 0.32% 0.35% 0.37% 0.25% N/A 0.45% 0.38% 0.22% 0.15%

Avg historical PCL % of loans - historical loan mix 0.40% 0.49% 0.64% 0.49% 0.51% 0.55% 0.57% 0.23% 0.39% - current loan mix 0.39% 0.38% 0.48% 0.50% 0.45% 0.50% 0.49% 0.20% 0.42%

* Based on historical median PCL rates for residential mortgages, consumer, business, and government portfolios since 1990 (or 2000 for National Bank). Source: Company reports, RBC Capital Markets

Loan mixes provide insights on credit risk. Disclosures related to Basel II provide key insights on the quality of retail loan books (how much is unsecured and how much is to higher-risk customers) as well as the quality of corporate loan books (non-investment grade compared to higher quality). The disclosures, however, are not always consistent. Different banks use different definitions for risk categories; furthermore, the level of detail provided on non- Canadian portfolios is much less granular. As time passes, we expect: 1) disclosures to become more comparable between banks; and 2) analysts will be able to create better time- series analysis to identify trends at individual banks.

 For readers interested in learning more about the type of analysis that may eventually be possible with consistent disclosures, please see our report “Basel II disclosures provide greater insight on banks’ exposures to credit deterioration” published on April 7, 2009.

Our current view on credit is for continued stability Provision for credit losses ratios are expected to be stable in 2014 and 2015. After four years in which credit was an important driver of relative earnings growth, credit is unlikely to be a driver of relative outperformance or underperformance in 2013, and we do not believe it will be the case in 2014/2015 either, as those years are likely to be fairly benign years from a credit cost standpoint. Key indicators of future loan losses are pointing to a stable environment for loan losses in all areas (business lending, personal lending, and mortgage lending).

 We believe that total provisions for credit losses will increase in 2014 and 2015, in line with growth in loans, with loss rates remaining below historical averages, as is typical for this stage of the credit cycle. Our forecast loan loss rates (0.38% in 2014 and 2015) are slightly below 2011 and 2012. The 20-year average historical loss rate is 0.49%. Key indicators of future loan losses are pointing to a stable environment for loan losses in all areas (business lending, personal lending, and mortgage lending).  We expect provisions for credit losses will remain at low levels in 2014 and 2015, with 2013 provisioning levels representing the trough levels in this cycle. We expect that the trough PCL rates will be at a higher level than the trough of the prior two credit cycles (~35 basis points versus ~25 basis points in the past two cycles) given lower expected recoveries and reversals. Loan mix has changed from the early 1990s and early 2000s as

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business loans have declined as a percentage of total portfolio, which is likely to result in less recoveries (recoveries can be material for business lending but are generally immaterial in consumer lending). The prior two credit cycles were characterized by problems in the business/corporate sector, whereas the more recent consumer-led credit cycle produces fewer opportunities for recoveries on unsecured consumer loans as banks do not recover much from bankrupt individuals.  Loan mix has changed from the early 1990s and early 2000s as business loans have declined as a percentage of total portfolio, which is likely to result in less recoveries available when credit conditions improve (recoveries can be material for business lending but are generally immaterial in consumer lending).  The prior two credit cycles were characterized by problems in the business/corporate sector, whereas the more recent consumer-led credit cycle produces fewer opportunities for recoveries on unsecured consumer loans as banks do not recover much from bankrupt individuals.  Loan loss allowance coverage ratios are low relative to historical levels, which leaves little room for loan loss allowance reversals. Total allowance ratios as a percentage of impaired loans are 97% compared to the 100-300% range from 1992 to 2005. The downward trend of allowance ratios on impaired loans implies higher expected recoveries on impaired loans than in the past.

Exhibit 136: We expect provisions for non-acquired loans to remain low in 2014 and 2015

Peaks Troughs PCL rates 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E Early '90s Early 2000s 2009-2012 Late 1990s Mid-2000s

Residential mortgage losses 0.01% 0.01% 0.04% 0.06% 0.05% 0.05% 0.05% 0.04% 0.04% 0.06% 0.01% 0.06% 0.01% 0.01% Consumer loan losses 1.00% 1.08% 1.47% 1.22% 1.06% 1.05% 1.00% 1.04% 1.05% 1.39% 1.24% 1.47% 0.85% 0.86% Business & govern't loan losses 0.10% 0.49% 0.91% 0.50% 0.34% 0.30% 0.21% 0.30% 0.30% 2.40% 2.34% 0.91% 0.17% -0.07% PCL rate 0.27% 0.43% 0.79% 0.53% 0.41% 0.41% 0.36% 0.38% 0.38% 1.53% 1.18% 0.79% 0.27% 0.23% Unadjusted for loan mix Total PCLs ($ millions, excludes RY) 1,974 3,939 7,655 5,102 5,104 5,280 4,977 5,671 5,985 Early Early Late Late Mid 1990s low 2000s low 2000s low 1990s high 2000s high Median ROE (reported cash) 21.0% 15.8% 10.1% 17.0% 20.6% 20.0% 16.7% 16.1% 16.5% 4.1% 11.0% 13.3% 18.8% 23.7% Median ROE (core cash) 20.4% 19.1% 17.5% 17.9% 19.4% 17.6% 16.4% 16.4% 16.5% 5.2% 11.9% 17.5% 18.1% 22.4%

Source: Company reports, RBC Capital Markets estimates

We forecast personal loss rates to be ~1.05% in 2014/2015, which is in line with the last three years. The most relevant predictors of personal loan losses, in our view, are employment growth and the change in the unemployment rate, which are pointing to a stable credit environment in personal lending.

 Canada witnessed rapid job creation coming out of the recession, and both growth and the unemployment rate have been in a fairly stable range since mid 2010. The unemployment rate of 7.1% remains the below average of the past 12 months. RBC Economics expects the unemployment rate to nudge lower to 6.7% in 2014. Personal bankruptcies have steadily declined since their peak in September 2009.  Canadian consumer leverage is higher than in the past, as are house prices. We do not believe that those two factors are necessarily triggers of potential credit issues, but, in the next employment cycle, they will likely exacerbate the credit losses in unsecured personal lending relative to past recessions.

We forecast business loss rates of ~0.30% in 2014 and 2015, which compares to ~0.20 – 0.35% in the last three years. The indicators of business loan losses that we track suggest a benign outlook. Indicators we track include credit spreads, rating agency downgrades and upgrades, tightening/easing underwriting standards, and employment growth. Canadian business loss rates are unlikely to improve much as they remained low throughout the

September 18, 2013 164 Canadian Bank Primer, Sixth Edition

recession but US loss rates remain higher than “normal”. Bank of Montreal and TD Bank are most exposed to US business lending, including commercial real estate, representing 16% and 11% of their loans, respectively.

Banks have small exposure to Canadian high-rise condo developers. We believe that condo construction would be the first area to be negatively impacted by a pull-back in house prices as it would likely cause decreased demand for new condos and potentially credit problems for developers.

Exhibit 137: Canadian condo developer exposure represents less than 0.4% of loans and less than 8% of CET1 capital

Note: Data as at Q3/13 for BNS, CIBC and TD. All other banks data as at Q2/13. Source: Company reports, RBC Capital Markets Research

We expect provisions for residential mortgages to remain minimal given stable Canadian employment and the structure of Canadian mortgage lending. We believe residential mortgage losses will be around 4 basis points in 2014/2015. Several factors explain the low credit risk of mortgages and why losses are low (including the full recourse nature of the loan and the structure of the mortgage insurance market in Canada, which has resulted in lower loan to value ratios on uninsured mortgages than in the US and a high level of insured mortgages – approximately 60% of the mortgages on bank balance sheets are fully insured).

We continue to believe that, for banks to suffer from increased losses in their residential mortgage books, unemployment would need to increase (which it has not) and significant house price declines would be needed given that high loan to value mortgages are insured and that uninsured mortgages have LTVs in the low 50’s. Beginning in 2013, OSFI has required the banks report the loan-to-value ratios on newly originated mortgages and HELOCS on a quarterly basis. The median loan-to-value on newly originated uninsured mortgages was 68% ranging from 63% at Scotiabank to 70% at National Bank. The median loan-to-value on HELOC’s (which include the amortizing mortgage portion of joint mortgage and HELOC products) was 66%, ranging from 58% at Bank of Montreal to 68% at National Bank.(Exhibit 138)

Exhibit 138: Canadian residential mortgage portfolios are 62% insured (Q3/13)

Canadian Residential Mortgages Uninsured New morgtage originations (average LTV) $ billions Insured Uninsured Loan-to-Value Uninsured Helocs BMO 86 59% 41% 59% BMO 68% 58% BNS 189 56% 44% 56% BNS 63% 65% CM 144 72% 28% 54% CM 68% 67% NA 36 67% 33% 55% NA 70% 68% RY 180 43% 57% 47% RY 68% 67% TD 158 65% 35% 47% TD 69% 61% Median 62% 38% 55% Median 68% 66% Total 793 464 329

Source: Company reports, RBC Capital Markets Research

September 18, 2013 165 Canadian Bank Primer, Sixth Edition

Exhibit 139: Loan losses have declined from their peak in 2009

2.0% 1.5%

1.60% 1.52% 1.5% 1.0% 1.18%

1.0% 0.88% 0.5%

0.5% 0.0%

-0.5% 0.0% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13E 14E 15E 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13E 15E

Total Loans* Consumer Loans Total PCL as % of Loans *based on total PCLs Residential Mortgage Business & Gov't

Total Big Six Banks. Prior to 1987, the banks used a rolling five-year average to estimate loan losses. Source: Company reports, RBC Capital Markets

September 18, 2013 166 Canadian Bank Primer, Sixth Edition

SECTION 8: Capital supports both expected and unexpected risks Banks need to hold capital in order to guard against the expected and unexpected risks inherent in their businesses, including credit risk, operational risk, market risk, and liquidity risk. This section reviews: 1) how regulatory capital is determined under the Basel III rules; 2) key capital indicators to track to determine capital strength; 3) the effect of new rules that have been introduced or are about to be introduced, on excess capital, capital deployment, and ROE; 4) how banks consider economic capital and rating agency capital requirements as supplementary constraints to regulatory capital requirements; and 5) future regulatory changes expected for liquidity, centralized counterparties for Over-the-counter (OTC) derivatives, and countercyclical capital buffers.

Regulatory capital rules have evolved over the past decade and most recently, in the first quarter of 2013, the Canadian banks began reporting capital ratios under the Basel III capital rules37 (Exhibit 140). The new Basel rules have had a negative effect on Canadian bank ROE relative to the 2006–2007 period as the Canadian banks adopted Basel III ahead of most global peers and currently all of the Canadian banks meet the 2019 minimum Basel III capital requirements, on an “all-in” basis. Given the strong profitability of the Canadian banks, they continue to generate ~20-30 basis points of common equity Tier 1 capital quarterly.

Capital needs to be held for both expected and unexpected risks, and we consider it to be the “second line of defence” against the cost of unexpected risks, with the “first line” being income generation.

 Capital is made up of common equity, permanent equity-like instruments, and subordinated debentures. Common equity has historically made up about 70% of capital, preferred shares 5–10%, hybrid instruments 5%, and debt 15–20%. Under Basel III, the common equity portion will increase, and hybrid instruments will eventually disappear as the definition of common equity Tier 1 capital and Tier 1 capital will be more restrictive than under the current regime.  The appropriate level of capital is not only a function of balance sheet assets but also the risk of those assets and risks not measured on balance sheets, such as guarantees and contingent liabilities.  Many constituents influence capital levels, including global and local regulators, rating agencies, management and boards of directors, as well as debt and equity investors. Protecting depositors is also fundamental to a bank’s operations and capital position.  Banks manage their capital structures from two main perspectives: regulatory capital and economic capital. Capital management is a balancing act between maintaining capital levels that satisfy regulators, providers of funds, and rating agencies, while also generating attractive returns for shareholders.  Higher leverage can contribute to a higher ROE, although the variability of ROE for Canadian banks has historically been more a function of variations in margins (return on assets) than leverage.  The two main metrics that we use to determine capital strength are common equity Tier 1 ratio (CET1) and the Tier 1 leverage ratio. We also monitor (to a lesser extent) the Tier 1 ratio, Total capital ratio, assets-to-regulatory capital multiple, and common equity-to- assets.

37 In Canada, banks began using Basel III capital rules in Q1/13. From 2008-2012, the banks had used Basel II capital rules, while prior to 2008 they had used Basel I capital rules. Basel III was created as a result of the 2008–2009 financial crisis and government bailouts of many banks around the world, with an objective to strengthen global capital (and introduce liquidity rules) by raising minimum capital ratio targets and improve the quality of capital, which would help absorb losses in periods of major banking system stress. September 18, 2013 167 Canadian Bank Primer, Sixth Edition

Exhibit 140: Canadian banks adopted Basel III in 2013 and meet 2019 minimum capital rules

Basel I Basel II Basel 2.5 Basel III

Created 1988 2004 2009 2010 Implementation Canadian banks ~1990 2008 2012 2013 Key considerations * To set an international framework for * Credit risk changes to be more granular * Market risk for trading books * To strengthen global capital and capital adequacy and bank-specific; were too low introduce liquidity rules * Primarly focused on credit risk * Introduce operational risk * Add capital charges for securitizations * Raise minimum targets and improve quality of capital to absorb shocks

Source: Company reports, RBC Capital Markets

Regulatory capital requirements based on risk profiles The Basel III risk-based capital targets are a common equity Tier 1 ratio of 7.0%, a Tier 1 ratio 8.5%, and a Total capital ratio of 10.5%. Additionally, OSFI has required a 1.0% buffer for Domestic Systemically Important Banks (D-SIB)38. Implementation of these minimum requirements will be phased-in globally by 2019, but OSFI required the Canadian banks to meet the 2019 minimums beginning in Q1/13. The ratios are calculated by dividing regulatory capital by risk-weighted assets, with the common equity Tier 1 being the most important of the three ratios. We summarize how both the capital ratio numerators and denominators are calculated.

Regulatory capital is divided into three tiers, with common shares and retained earnings being the predominant form of Tier 1 capital.

 Common Equity Tier 1 comprises the highest-quality capital and consists of common equity, retained earnings, accumulated other comprehensive income, qualifying minority interest in subsidiaries, and other elements. A number of regulatory deductions are made, including goodwill and intangibles, unconsolidated investments in banking, financial, and insurance entities, certain deferred tax assets (DTAs) such as loss carryforwards, and defined benefit pension fund liabilities. In addition, three deduction items are given some recognition in common equity and capped at 10% of common equity instead of a full deduction: significant unconsolidated investments in banking, financial, and insurance entities; DTAs arising from temporary differences; and mortgage servicing rights.39  Additional Tier 1 capital includes eligible perpetual preferred share instruments that meet certain criteria (including having no maturity date with no step-ups or redemption incentives and the bank having full dividend and/or coupon discretion), and certain minority interests in subsidiaries.  Tier 2 capital contributes to the bank as a going concern by providing loss absorption. This includes subordinated debentures and certain loan loss provisions or reserves (e.g., banks using the standardized method, as discussed on the next page, can also include general allowance for credit losses up to a limit of 1.25% of credit risk-weighted assets).

Risk-weighted assets are determined by adding up capital requirements for exposure to credit risk, operational risk, and market risk, and banks are given options to determine the amount of capital required (Exhibit 141). In 2012, Canadian banks, along with many global

38 As per OSFI’s March 2013 Advisory, Canadian D-SIBs are Bank of Montreal, Scotiabank, CIBC, National Bank, Royal Bank and TD Bank. 39 For all definitions and rules, please see the Basel Committee on Banking Supervision document Basel III: A global regulatory framework for more resilient banks and banking systems (December 2010). September 18, 2013 168 Canadian Bank Primer, Sixth Edition

banks, implemented new market risk rules that increased market risk capital requirements. Beginning in the first quarter of 2014, the Canadian banks’ will be subject to an additional CVA charge, which will further increase capital requirements. The negative impact to common equity Tier 1 ratios from the additional CVA40 charge ranges from 45 basis points at CIBC to 25 basis points at National Bank, but will be subject to a five-year phase-in period.41

 Credit risk (80% of regulatory capital requirements) is the risk of financial loss due to a borrower or counterparty failing to meet its obligations in accordance with agreed terms. Credit risk is traditionally thought of in the context of loans, but it can also occur in areas such as derivatives, guarantees provided, trading books, and reinsurance. The most basic (standardized) approach is based on prescribed risk weights on loan categories, and the most advanced method (Advanced Internal Ratings Based or AIRB approach) requires banks to determine their own capital requirements based on a combination of their historical loss experiences and expected losses (which are a function of probabilities of default in the next year, exposure at default, and loss given default42), subject to regulatory approval. The Big Five Canadian banks adopted the AIRB approach with the implementation of Basel II in the first quarter of 2008, while National Bank became ready for the AIRB approach in the first quarter of 2010. The two regional banks, Canadian Western Bank and Laurentian Bank, have not yet adopted AIRB, but have been making progress and hope to adopt AIRB in the next five years.  Operational risk (13% of regulatory capital requirements) is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events, including legal and fraud risk, but excludes strategic and reputational risk. The most basic approach to determining operational risk is based on revenues, with capital charges dependent on the source of revenues. The capital requirement is about 15% of revenues, varying from 12% for simpler businesses (retail banking, brokerage, and asset management) to 18% for more complex businesses (corporate finance, trading and sales, and payments and settlements). OSFI allows banks with sophisticated systems and operational loss history to come up with their own estimates of operational risk capital under an Advanced Measurement Approach, with models subject to approvals; however, banks may be at different stages of systems development estimate operational risk properly based on loss data (for events such as lawsuits, tax violations, and fraud), scenario analysis, internal control factors, and the business environment. As of the third quarter of 2013, all banks were using the standardized approach for operational risk except CIBC, which adopted the advanced approach at the beginning of 2008.43  Market risk (6% of regulatory capital requirements) is the risk of losses in on- and off- balance sheet positions arising from market price movements on risk positions such as interest rate, equity, commodities, and foreign exchange. New rules for market risk were implemented in the first quarter of 2012 (Basel 2.5), which increased capital requirements for market risk. The most basic standardized approach for market risk assigns a capital charge for specific risk categories such as interest rate and equity

40 Credit Valuation Adjustment (CVA) is the mark-to-market gain/loss associated with a deterioration/improvement in the credit worthiness of a derivative counterparty. Under Basel III banks are subject to a capital charge for potential mark-to-market losses (i.e. CVA) associated with a deterioration in the credit worthiness of a counterparty. 41 On August 21, 2013, OSFI released two options for the Canadian banks to phase in the additional CVA charge to risk-weighted assets, under Basel III. The banks will phase in the negative impact to capital ratios over a 5-year period, beginning in January 2014. The 5 year phase-in period will start with 57% to 77% of negative impact being recognized in Q1/14 and end with 100% recognized in Q1/19. 42 Exposure at default is how much a debt borrower would have at the moment of default. Loss given default is loss after recoveries. 43 We think several banks are taking steps to implement the Advanced Measurement Approach for operational risk and could be ready in upcoming years. September 18, 2013 169 Canadian Bank Primer, Sixth Edition

positions; general market risk charges are applied for all other positions including commodities and foreign exchange. Banks can also use internal models44 to calculate the capital charge if approved by OSFI, or a mix of both a models-based and standardized approaches.  Market risk represents 6% of risk-weighted assets in aggregate for the Canadian banks, with Royal Bank above the average and with CIBC, Bank of Montreal and TD below as of the second quarter of 2013.  Market risk capital requirements for Canadian banks increased by a median 65% with the adoption of the Basel 2.5 market risk rules in Q1/12 and ranged from 30% at CIBC to almost 300% at TD Bank. The average impact was generally lower than for many international banks because Canadian banks were not as exposed to securitized assets as many of their global peers, and we believe they were able to exit some of the positions that attracted higher capital charges. Canadian banks in general were not dominant players in structured finance, relative to many multinational investment banks.  The new capital requirements that are specific to wholesale markets (including the counterparty credit risk component of Basel III that will be introduced in Q1/14) affect trading businesses more than lending and underwriting businesses and, within trading, affect fixed income businesses more than equities and foreign exchange businesses. Areas of fixed income that are particularly affected include structured products and the trading of non-investment grade securities. Proprietary trading and derivatives trading are seeing capital requirements increase much more than client-driven agency trading.  The objective of the revised Basel 2.5 market risk framework was to address some of the areas where regulators (and banks) realized that risk weightings were too low following the market turmoil of 2007 until mid-2009. For example, banks and regulators came to the conclusion that: 1) risk weightings for trading books were too low when the main driving metric (VaR) was calculated in an environment of low volatility and low correlations between asset classes; 2) credit and liquidity risk in trading books was underestimated; and 3) structured-finance holdings were riskier than previously thought, and the holdings of certain tranches in trading books attracted much lower risk weightings than in banking books. Relative to the old rules, the rules for the trading book are now stricter because VaR calculations are more conservative, credit-sensitive positions in trading books attract higher capital charges, and securitization transactions are now treated as if they were held in the banking book, therefore attracting more capital than if treated as trading positions.

44 The internal models-based approach uses the VaR technique and is encouraged for banks with significant trading activities. It must meet a number of conditions including stress testing, back testing, management oversight, general procedural, and qualitative standards. September 18, 2013 170 Canadian Bank Primer, Sixth Edition

Exhibit 141: Credit risk makes up 81% of RWA

RWA breakdown At Q3/13 ($ millions) BMO BNS CM NA RY TD Total

Credit risk 176,926 236,300 112,200 49,258 233,527 237,928 82.6% 83.7% 83.7% 80.9% 74.2% 83.9% 81.1%

Market risk 10,758 14,500 3,400 3,252 37,933 11,134 5.0% 5.1% 2.5% 5.3% 12.0% 3.9% 6.3%

Operational risk 26,549 31,500 18,400 8,385 43,344 34,459 12.4% 11.2% 13.7% 13.8% 13.8% 12.2% 12.6%

Total RWA 214,233 282,300 134,000 60,895 314,804 283,521

Source: Company reports, RBC Capital Markets

Credit risk determination is based on individual banks’ risk profiles under Basel III, which became the case when Basel II was introduced. Canada was among the earlier countries to adopt the new risk-based capital standards, which are intended to reflect individual banks’ risk profiles better than Basel I. By refining capital standards, the BCBS wanted to ensure that banks with higher risk or less sophisticated risk-management procedures are required to hold more capital, while allowing more sophisticated banks and those with less risk to operate with less capital.

 Under Basel II (and now Basel III), the calculation of capital requirements for credit risk is more granular and bank-specific, and a new capital charge was added for operational risk that did not exist under Basel I. Capital methodologies for market risk did not change when Basel II was introduced but changed when Basel 2.5 was introduced. In general, banks that have a sophisticated enough infrastructure to collect the data necessary to adopt advanced approaches in measuring and understanding risk and operate in a way that is consistent with what regulators expect of sophisticated banks are rewarded with lower capital requirements.  In general, standardized approaches for capital requirements are based on prescribed capital charges or risk weights based on specific categories. For example, credit-risk capital is based on prescribed risk weights on different loan categories (a corporate loan rated AAA would have a risk weight of 20% while a loan rated below BB- would have a risk weight of 150%), operational-risk capital charges are a percentage of revenue dependent on the type of business, and market-risk capital charges are assigned for specific risk categories such as interest rate and equity positions.  Advanced approaches for credit, market, and operational risk require banks to determine their own capital requirements using internal models and subject to OSFI approval. For example, credit-risk capital is based on a bank’s historical loss experiences and expected losses; operational-risk capital is based on models incorporating bank- specific experience and internal controls; and market-risk capital is based on internal models using VaR techniques meeting procedural and testing standards.  Capital requirements, therefore, vary from bank to bank, but risk weightings are roughly as follows for Canadian exposures: 0% for insured residential mortgage, 10–15% for uninsured residential mortgages and HELOCs; 25–35% for unsecured credit; 20–25% for investment-grade corporate credit; and 75–85% for non-investment-grade corporate credit. Those percentages vary from bank to bank and within product categories (for example, most banks will have different risk ratings in their mortgage books, ranging from low risk to in default, with different capital being allocated to each category).

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 Most Canadian banks benefited from the introduction of Basel II in 2008 (by an average of 50 basis points to the Tier 1 ratio) because the declines in risk-weighted assets for credit risk generally outweighed the introduction of risk-weighted assets for operational risk. National Bank was initially negatively affected by Basel II, unlike its peers, because it was behind the Big Five Banks in adopting the AIRB methodology for determining credit risk (whereas the new operational-risk charge affected them). In the first quarter of 2010, when National Bank received full approval, its Tier 1 ratio rose by about 145 basis points as a result. Canadian Western Bank and Laurentian Bank continue to use the Standardized approach for credit risk.

Exhibit 142: Canadian bank Tier 1 ratios benefited from introduction of Basel II

Difference in Basel I Q4/08 between Basel II Q1/08 Q2/08 Q3/08 Q4/08 Basel I and II Q1/08 Q2/08 Q3/08 Q4/08 Bank of Montreal 9.1% 9.0% 9.5% 9.4% 0.4% 9.5% 9.4% 9.9% 9.8% Scotiabank 8.9% 8.5% 8.6% 8.2% 1.1% 9.0% 9.6% 9.8% 9.3% CIBC 10.6% 9.4% 9.0% 9.0% 1.5% 11.4% 10.5% 9.8% 10.5% National Bank 9.8% n/a n/a n/a n/a 9.3% 9.2% 10.0% 9.4% Royal Bank 9.2% 8.8% 8.7% 8.3% 0.7% 9.8% 9.5% 9.5% 9.0% TD Bank 10.2% 8.9% 9.2% 9.6% 0.2% 10.9% 9.1% 9.5% 9.8% Median 9.5% 8.9% 9.0% 9.0% 9.7% 9.5% 9.8% 9.6%

Source: Company reports, RBC Capital Markets

Basel III regulatory capital requirements are more restrictive In 2013, the Canadian banks adopted Basel III capital requirements issued by the BCBS45. Globally, the Basel III capital rules are being introduced on a phased-in basis which began in 2013, as shown in Exhibit 143, and will not be fully implemented until 2019. The Canadian banks were required by OSFI to meet most of the 2019 capital rules on a fully phased-in basis, in Q1/13.

The new capital requirements are measured in four different ways: three are risk-based capital ratios (the common equity Tier 1 ratio, Tier 1 capital ratio, and Total capital ratio all focus on credit, market, and operational risks faced by banks on and off their balance sheets); and the fourth is a Tier 1 capital leverage ratio that provides a measure of a balance sheet check. The minimum target ratios are:

 Common equity Tier 1 ratio of 7.0%, which includes a capital conservation buffer.  Tier 1 ratio of 8.5%  Total capital ratio of 10.5%; and  Tier 1 leverage ratio of 3.0%.  A capital conservation buffer of 2.5% is included in the above capital ratio minimums, and breaching the buffer would limit capital distribution including dividend payments and discretionary bonuses.  In addition to meeting Basel III requirements, global systemic important financial institutions (G-SIFIs) must carry an additional 1-2.5% buffer, depending on the bank’s systemic importance. Although no Canadian banks are on the list of globally systemically important financial institutions, they are all prescribe by OSFI as domestically

45 The Basel III global regulatory capital framework and Basel III International framework for liquidity risk were published December 2010. September 18, 2013 172 Canadian Bank Primer, Sixth Edition

systemically important and are required to carry an additional 1% capital buffer above the above prescribed minimums.  A bank at the minimum capital target would not be allowed to pay dividends, a bank with capital ratios well in excess of regulatory minimums could pay out 100% of earnings, and banks in the middle would be allowed to pay out a certain percentage of earnings that depends on how far capital ratios are from minimum targets (for example, a bank with common equity Tier 1 ratio above 6.375% but below the minimum 7.0% must keep 40% of its earnings, while a bank between 4.5% and 5.125% must keep all of its earnings).

The Basel III capital rules are more restrictive than the prior Basel II rules from the following perspectives:

 The definition of capital is more restrictive. For example, there are limits on how much capital can be composed of significant minority stakes, deferred tax assets, and mortgage servicing rights, and other items such as intangibles no longer count (whereas under Basel II some of Tier 1 capital could consist of intangibles). These changes began being phased in at the beginning of Q1/13, although, as we mentioned above, OSFI required the Canadian banks to meet the full rules in Q1/13, without the benefit of the phase-in for the common equity Tier 1 ratio.  The minimum target ratio is based off a more punitive view of capital (common equity Tier 1). Previously, OSFI had a minimum Tier 1 target ratio of 7%, which had to be made up of 60% common equity, which implied a 4.2% minimum common equity Tier 1 ratio (without the impact of new prescribed regulatory deductions). The new target common equity Tier 1 ratio is significantly higher, at 7.0% and on a tighter definition of capital (which includes direct regulatory deductions not required under Basel II).  New rules for market risk were implemented in Q1/12. Market risk used to represent ~4.5% of risk-weighted assets in aggregate for the Canadian banks, with Royal Bank and National Bank above the average and CIBC and TD below as of Q4/11. Risk weighted assets for market risk rose by a median 65% from Q4/11 to Q1/12 and now represent ~6% of risk-weighted assets, with Royal Bank (10%) and TD (6%) above the average, and CIBC (3%) and Bank of Montreal (4%) below.  The additional credit valuation adjustment (CVA) charge will be introduced in Q1/14, with a five-year phase in period. For the big 6 banks that we cover the negative impact of the CVA charge to common equity Tier 1 ratios range from ~45 basis points at CIBC to ~25 basis points at National Bank.  New requirements for liquidity are also being introduced. We believe that upcoming regulatory rules for liquidity require greater adjustment for banks larger in capital markets and for banks with lower proportions of retail funding. The new liquidity rules are negative for net interest income margins all else being equal, with the final impact depending on how much of the costs banks can pass on to their customers. Among the banks, we believe TD will be least impacted by the new rules. The Basel III Liquidity Coverage Ratio will be introduced in 2015 and the Net Stable Funding ratio in 2018, but we believe that OSFI, based on its prior track record of implementing global regulation early, could push Canadian banks to adopt some of the liquidity proposals earlier. In fact, some of the behaviours we are observing are indicative of banks already being more conservative in their liquidity risk management, including more competitive pricing for retail term deposits, reductions in off-balance sheet commitments, greater holdings of liquid assets, and extension of term when funding wholesale. (Exhibit 134)  BCBS published updated guidelines to its liquidity coverage ratio in January 2013, which we view as positive for the Canadian banks, as the rules were somewhat loosened. The changes that were made had to do with what could be included in

September 18, 2013 173 Canadian Bank Primer, Sixth Edition

the stock of high quality liquid assets (HQLA), the haircuts which are to be applied to certain assets, such as equities and a graduated approach to compliance with the LCR by 201946 was introduced to ensure that the LCR can be introduced without material disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity.

Exhibit 143: Canadian banks will adopt Basel III liquidity rules starting in 2015

All dates as of January 1 2011 2012 2013 2014 2015 2016 2017 2018 2019

Common equity capital ratio - minimum 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5% Capital conservation buffer 0.625% 1.25% 1.875% 2.5% Common equity capital ratio - minimum plus buffer 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0% Deductions from Common equity Tier 1 * 20% 40% 60% 80% 100% 100%

Minimum Tier 1 capital - minimum 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0% Minimum Tier 1 capital - minimum plus buffer 4.5% 5.5% 6.0% 6.6% 7.3% 7.9% 8.5%

Minimum Total capital - minimum 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% Minimum Total capital - minimum plus buffer 8.0% 8.0% 8.0% 8.6% 9.3% 9.9% 10.5%

Capital instruments that no longer qualify ** Phased out over 10 year horizon beginning 2013

Leverage ratio - testing of 3% minimum Supervisory monitoring Parallel run - Disclosure starts January 1, 2015 Pillar 1 migration

Observation Introduce Liquidity coverage ratio period minimum begins standard Observation Introduce Net stable funding ratio period minimum begins standard

* Deductions include amounts exceeding the limit for deferred tax assets, certain financial investments, and mortgage servicing rights. ** Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital will be phased out over 10 years with recognition capped at 90% from January 1, 2013, and the cap reducing by 10% in each subsequent year. Source: Basel Committee on Banking Supervision, RBC Capital Markets

Canadian banks are well capitalized The combination of income growth, internal capital generation, and greater clarity on regulatory capital rules position the Canadian banks to consider dividend increases, balance sheet optimization, and other capital deployment. All eight banks have increased their dividends since the end of the recession and five have common share buyback programs in place. We believe all the banks will consider preferred and common share buybacks in upcoming years, as well as the repurchase of hybrid securities. We also believe that banks might look at capital deployment opportunities with a somewhat lower degree of caution than in past years, although we continue to expect banks will look to operate with a cushion of 0.5-1.0% points over OSFI’s minimum common equity Tier 1 ratio target of 8.0% (including a 1% D-SIB buffer) before considering opportunities that have a material negative impact on stated capital ratios.

Capital deployment is likely to increase in 2014 and 2015 based on current capital positions and expected organic growth. The Canadian banks have greater clarity on the regulatory and economic environment47 than they did, and their capital positions under the Basel III rules

46 The new BCBS liquidity coverage ratio guidelines outlined a graduated approach to compliance by 2019. Banks must meet a 60% LCR ratio by January 1st, 2015 and then an additional 10% must be built each year thereafter, until full compliance of 100% by January 1st, 2019. 47 One area of potential remaining uncertainty is leverage. Canadian banks meet current OSFI leverage requirements and we believe they already meet the Basel leverage requirements that will be introduced in 2018. Bank regulatory capital rules continue to evolve, however, with global and local September 18, 2013 174 Canadian Bank Primer, Sixth Edition

have improved as capital has built organically. We believe that the combination of the above factors will lead to share buybacks and higher acquisition activity, but with a higher percentage of common stock being used to finance acquisitions than in the past, although cash will increasingly be used in 2014/2015 versus 2011-2013.

 We use a minimum target of 9.0%, which is based on adding a 1.0% cushion above OSFI’s targeted requirement of 8.0%, which includes a 1% domestic systematically important bank (D-SIB) buffer. Canadian banks historically have had capital ratios in excess of minimum OSFI targets, and we think a 0.5-1.0% cushion is reflective of what banks in general might target.  CIBC , Royal Bank and Bank of Montreal are currently over 9.0% already, whereas we expect the other three large cap banks we cover to reach that level by the first half of 2014.  Now that banks have received clarity from OSFI on D-SIB buffers and the scheduled phase-in of the additional CVA charge, the likelihood of buybacks and/or cash acquisitions will increase, in our view.

We expect regular dividend increases from banks, although at a slower growth rate than investors were accustomed to in the 2000-2007 period. Dividend growth was rapid during that period for two reasons: (1) earnings per share growth was rapid (CAGR of 11%); and (2) dividend payout ratios rose to 40% from about 30%. We believe dividend increases will continue; however, the dividend increases will likely be in line with earnings growth (so dividend growth will not exceed EPS growth as was the case from 2000 to 2007). Of the large cap banks, we believe that TD Bank and National Bank are likely to increase dividends faster as their payout ratios are at the low end of their target ranges.

We expect most banks to look to reduce the amount of preferred shares and hybrid notes they have outstanding (especially if there are redemption/call dates) as: (1) new regulation will put greater emphasis on common equity Tier 1 capital than total capital or total Tier 1 capital; (2) existing forms of non-common capital will be gradually phased out over 10 years starting in 2013 and will need to be replaced with capital that is convertible into common equity in distressed situations; and (3) banks will likely hold less non-common Tier 1 capital than in the past given that the cost is likely to increase and the banks currently hold more non-common Tier 1 capital than they need, in our view. Several banks redeemed non- common capital in the past two years and we expect more preferred share or hybrid security.

The adoption of IAS 19 in Q1/14 would have a negative impact on book value and capital, and a modest positive impact on earnings, although the impacts could be smaller given the recent rise in medium- and long-term rates. IAS 19 is the pension accounting standard that the Canadian banks, under IFRS, are required to adopt in Q1/14. IAS19 requires the immediate recognition of all changes to the funded position of the banks’ employee benefit plans, versus the corridor approach that the banks currently elect (Canadian Western Bank, and as at Q4/12, National Bank, already conform with the standard). When the banks adopt IAS 19 in Q1/14 they will be required to reduce retained earnings by the current unfunded portion of their employee benefit plans, which would reduce book values across the banks.

regulators studying discrepancies in risk weighted calculations and the proper way to measure leverage (and whether leverage should be a primary or secondary constraint). US regulators have proposed using a leverage ratio in 2018 that is stricter than the Basel requirement for eight US banks. We do not have reason to believe that OSFI will introduce a stricter requirement than Basel at this time. For greater detail, please see our report published on July 15th, 2013, “Canadian banks are well positioned for Basel leverage ratio” September 18, 2013 175 Canadian Bank Primer, Sixth Edition

We estimate that the impact to book value to range from 2% at Bank of Montreal, Scotiabank and TD Bank to 5% at Laurentian Bank (Exhibit 144). Basel III common equity Tier 1 ratios will be marginally impacted as the hit to retained earnings is partially offset by the de-recognition of the banks’ pension assets, which currently is a direct deduction to Basel III common equity Tier 1 capital. We estimate that the Basel III common equity Tier 1 impacts will range from ~20 basis points at Bank of Montreal to ~40 basis points at Laurentian Bank and CIBC. Canadian lifecos faced the same issue as at Q1/13 and, in their case, OSFI is allowing them to phase in the capital impact over eight quarters. At this time, we do not know how OSFI plans on treating the capital impact for banks. From an earnings perspective, the change is positive as it eliminates an amortization expense that currently exists.

Exhibit 144: Implementation of IAS 19 in Q1/14 will have a negative impact on book value and capital; positive on ROE

Summary of IAS 19 impacts

After-tax Q1/14E Q1/14E Impact to 2014E 2014E Impact to Q1/14E Q1/14E Impact to Impact to Retained BV per share BV per share Book Value ROE ROE 2014E ROE BIII CET1 ratio BIII CET1 ratio Q1/14E BIII CET1 Earnings ($,mm) Excl. IAS19 ($) ($) (%) Excl. IAS19 (%) (%) Excl. IAS19 (%) ratio (%) BMO -680 43.95 42.89 -2.4% 14.3% 14.7% 0.4% 9.7% 9.5% -0.2% BNS -912 34.19 33.44 -2.2% 15.8% 16.1% 0.3% 9.3% 9.0% -0.3% CM -706 41.87 40.09 -4.3% 19.5% 20.2% 0.7% 9.2% 8.9% -0.4% TD -964 52.27 51.23 -2.0% 15.9% 16.2% 0.3% 9.1% 8.8% -0.3% LB -72 45.89 43.37 -5.5% 11.8% 12.4% 0.6% 7.7% 7.3% -0.4%

Note: Impacts assume that there is no change in interest rates or actuarial assumptions. Source: Company reports, RBC Capital Markets estimates

September 18, 2013 176 Canadian Bank Primer, Sixth Edition

Exhibit 145: All banks have increased their dividend recently

Big 6 banks Regional Banks Dividend Payout Ratios BMO BNS CM NA RY TD Median CWB LB Last Stated Target Payout Ratio 40%-50% 40%-50% 40%-50% 40%-50% 40%-50% 40%-50% 25%-30% 40%-50%

Median 2003-2012 48% 45% 42% 39% 44% 38% 43% 23% 39%

% Change 2000 to 2012 16% 18% 19% 10% 15% 18% 17% 14% 10%

Payout Ratio = Common dividend divided by Core cash net income to common shareholders. Source: Company reports, RBC Capital Markets

September 18, 2013 177 Canadian Bank Primer, Sixth Edition

Exhibit 146: Capital management varies from bank to bank

Capital Returned to Shareholders ($ millions)

Bank of Montreal ($ millions) 2007 2008 2009 2010 2011 2012 Median 2013E 2014E 2015E GAAP net income $2,087 $1,897 $1,667 $2,674 $2,897 $3,979 $4,026 $4,097 $4,159 Common shareholder dividends 1,353 1,410 1,530 1,571 1,690 1,820 1,906 1,982 2,072 Share buybacks (net of shares issued) 279 (182) (1,425) (729) (4,405) (625) 365 272 300 Dividend payout ratio 64.8% 74.3% 91.8% 58.8% 58.3% 45.7% 45.7% 47.3% 48.4% 49.8% Total capital returned as % of GAAP net income 78.2% 64.7% 6.3% 31.5% -93.7% 30.0% 32.5% 56.4% 55.0% 57.0%

Scotiabank 2007 2008 2009 2010 2011 2012 Median 2013E 2014E 2015E GAAP net income $3,994 $3,033 $3,361 $4,139 $4,965 $6,023 $6,235 $6,660 $7,264 Common shareholder dividends 1,720 1,896 1,990 2,023 2,200 2,493 2,862 3,147 3,485 Share buybacks (net of shares issued) 517 (263) (1,117) (804) (2,586) (4,803) (1,382) (1,240) (1,240) Dividend payout ratio 43.1% 62.5% 59.2% 48.9% 44.3% 41.4% 43.1% 45.9% 47.3% 48.0% Total capital returned as % of GAAP net income 56.0% 53.8% 26.0% 29.5% -7.8% -38.4% 53.8% 23.7% 28.6% 30.9%

CIBC 2007 2008 2009 2010 2011 2012 Median 2013E 2014E 2015E GAAP net income $3,082 $(2,182) $1,012 $2,283 $2,690 $3,173 $3,310 $3,446 $3,392 Common shareholder dividends 1,044 1,285 1,328 1,350 1,391 1,470 1,521 1,557 1,587 Share buybacks (net of shares issued) 208 (2,963) (178) (563) (575) (393) 522 672 696 Dividend payout ratio 33.9% n.m. 131.2% 59.1% 51.7% 46.3% 46.3% 46.0% 45.2% 46.8% Total capital returned as % of GAAP net income 40.6% 76.9% 113.6% 34.5% 30.3% 33.9% 37.5% 61.7% 64.7% 67.3%

National Bank of Canada 2007 2008 2009 2010 2011 2012 Median 2013E 2014E 2015E GAAP net income $519 $744 $795 $971 $1,171 $1,518 $1,455 $1,433 $1,524 Common shareholder dividends 363 394 398 402 445 498 551 617 667 Share buybacks (net of shares issued) 257 (57) (73) (75) (212) (84) (123) (77) (77) Dividend payout ratio 70.0% 52.9% 50.0% 41.4% 38.0% 32.8% 38.0% 37.9% 43.1% 43.8% Total capital returned as % of GAAP net income 119.4% 45.2% 40.9% 33.7% 19.9% 27.3% 54.6% 29.5% 37.7% 38.7%

Royal Bank of Canada 2007 2008 2009 2010 2011 2012 Median 2013E 2014E 2015E GAAP net income $5,404 $4,454 $3,949 $5,474 $6,611 $7,235 n/a n/a n/a Common shareholder dividends 2,321 2,624 2,832 2,868 3,061 3,348 n/a n/a n/a Share buybacks (net of shares issued) (104) (147) (2,691) (303) (639) (335) n/a n/a n/a Dividend payout ratio 42.9% 58.9% 71.7% 52.4% 46.3% 46.3% 46.3% n/a n/a n/a Total capital returned as % of GAAP net income 41.0% 55.6% 3.6% 46.9% 36.6% 41.6% 39.7% n/a n/a n/a

TD Bank 2007 2008 2009 2010 2011 2012 Median 2013E 2014E 2015E GAAP net income $3,977 $3,770 $2,954 $4,449 $5,761 $6,171 $6,555 $7,526 $8,479 Common shareholder dividends 1,517 1,851 2,075 2,118 2,316 2,621 2,980 3,348 3,615 Share buybacks (net of shares issued) 183 (529) (2,079) (1,319) (1,687) (1,200) (301) 0 0 Dividend payout ratio 38.1% 49.1% 70.2% 47.6% 40.2% 42.5% 45.0% 45.5% 44.5% 42.6% Total capital returned as % of GAAP net income 42.7% 35.1% -0.1% 18.0% 10.9% 23.0% 33.1% 40.9% 44.5% 42.6%

Source: Company reports, RBC Capital Markets

Key capital indicators to monitor The two main metrics that we use to determine capital strength are common equity Tier 1 ratio (CET1) and the Tier 1 leverage ratio. We also monitor (to a lesser extent) the Tier 1 ratio, Total capital ratio, assets-to-regulatory capital multiple, and common equity-to-assets.

Canadian banks have capital ratios that are higher than in the past and they continue to generate capital organically (Exhibit 147). Furthermore, during the most recent financial

September 18, 2013 178 Canadian Bank Primer, Sixth Edition

crisis, their capital was all raised privately, in contrast to many foreign banks, which had to rely on government support.

 Common equity Tier 1 to risk-weighted assets under current rules range from 8.6% to 9.6% as of the third quarter of 2013, while Tier 1 ratios range from 11.0% to 11.6%.  Capital strength is more valuable in a difficult macro environment when economic uncertainty rises and earnings become unpredictable, because well capitalized banks: 1) are better positioned to withstand negative surprises and rising credit losses; 2) can take advantage of organic and acquisition opportunities; and 3) will be under less pressure to strengthen their capital ratios at a time when valuations have declined.  Determining capital adequacy is not a black-and-white exercise, but rather an exercise that requires judgment, particularly around ultimate loan losses and writedowns, as well as ongoing income generation. Capital adequacy has to be judged against multiple factors at the same time. For example, writedowns affect the capital of banks that have poor income generation, whereas they only affect income for banks that are more profitable. Also, looking at stated capital ratios is only a starting point because it does not reflect all risks or upcoming income generation. Lastly, dividends have to be part of the conversation as well because banks with lower payout ratios have less ongoing pressure on capital generation.  Analysts should not expect too much help from management teams on capital ratios. Banks provide long-term targets, but actual levels can vary in time. Furthermore, a bank that knows it will need capital is not likely to say, “we are not well capitalized and need to raise more” since it would: 1) raise the cost of that eventual capital raise; and 2) likely lead to a loss of confidence in the bank’s strength, and without confidence, an institution’s access and/or cost of funds can worsen rapidly.

Exhibit 147: Canadian banks’ Tier 1 common and Tier 1 ratios have increased

Bank Capital Ratios Tier 1 Capital Ratios (Annual since 1988) (Annual since 1988) 16% 14%

14% 12%

12% 10%

10% 8%

8% 6%

6% 4%

4% 2% 88 90 92 94 96 98 00 02 04 06 08 10 12 14E 88 90 92 94 96 98 00 02 04 06 08 10 12 Tangible Common Equity as % of RWA Common Equity % RWA Tier 1 Capital Ratio Tier 1 common / RWA Canadian banks U.S. banks Basel III pro forma common equity Tier 1 ratio

Note: US banks include C, BAC, JPM, BBT, FITB, KEY, STI, USB, WFC, GS, and MS. Source: Company reports, SNL Datasource, RBC Capital Markets

Common equity Tier 1 to risk-weighted assets is the most important measure of capital adequacy, in our view. The denominator is risk weighted to reflect the risk characteristics of a bank’s business, not just how big its balance sheet is. The numerator is of higher quality than the Tier 1 ratio calculation because it only includes common equity, with additional regulatory deductions made for unconsolidated investments, certain deferred tax assets (DTAs) and mortgage servicing rights. Historically, most regulators and analysts focused on Tier 1 common and Tier 1 ratios, but the focus has shifted to common equity Tier 1.

September 18, 2013 179 Canadian Bank Primer, Sixth Edition

 The common equity Tier 1 target for the Big Six Canadian banks is currently 8.0%, including the D-SIB buffer. Prior to the adoption of Basel III, there were no formal minimum targets for Tier 1 common ratios in Canada, but 60% of Tier 1 capital (prior minimum target of 7%) had to be made up of common equity or an approximate minimum of 4.2%.  The level of common equity Tier 1 capital is a trade-off between protecting against negative surprises and the cost (lower returns on capital). We believe that it is prudent for banks to hold excess capital, especially in a challenging macro environment, because investors value a high common equity Tier 1 ratio to protect against possible losses in such an environment.  Reported common equity Tier 1 ratios are point-in-time measures and are not forward- looking. As such, it is important for investors to consider items that might affect future capital ratios, such as net income, dividends, potential gains and losses and/or share buybacks.  Common equity Tier 1 to risk-weighted assets under current rules range from 8.6% to 9.6% as of the third quarter of 2013, while Tier 1 ratios range from 11.0% to 11.6%. (Exhibit 149)

Exhibit 148: Estimated capital ratios under Basel III rules; all the big 6 banks currently meet the 8% minimum

Q3/13 Big Six Banks (ex. RY) Regionals (C$, milllions) Basel III: Common Equity Tier 1 BMO BNS CM NA TD Total CWB LB Common equity tier 1 (before regulatory adjustments) 27,374 39,571 16,127 7,328 46,027 136,427 1,353 1,269 Regulatory adjustments (6,747) (14,383) (3,644) (2,093) (20,674) (47,541) (110) (255) Core common equity tier 1 20,627 25,188 12,483 5,235 25,353 88,886 1,244 1,014 Basel III: Risk Weighted Assets Reported Basel III RWA 214,233 282,309 133,994 60,895 283,521 974,952 15,846 13,472 Common equity tier 1 ratio 9.6% 8.9% 9.3% 8.6% 8.9% 9.1% 7.8% 7.5%

Q3/13 Big Six Banks (ex. RY) Regionals (C$, milllions) Basel III: Tier 1 Leverage Ratio BMO BNS CM NA TD Total CWB LB Reported Tier 1 Capital 1 23,986 31,041 15,578 6,972 31,077 108,654 1,516 1,219 Estimated exposure Total on-balance sheet assets (ex. derivatives) 517,693 716,473 376,832 181,063 785,255 2,577,316 17,925 33,656 Derivative exposure (credit and non-credit derivatives) 2 12,965 80,233 562 1,851 2,374 97,985 0 0 Potential future credit add-on3 12,264 24,661 17,534 4,908 18,651 78,018 0 0 Off-balance sheet exposure 4 16,198 39,684 27,966 19,243 20,282 123,373 883 1,021 Deductions from common equity Tier 1 under Basel III (6,747) (14,383) (3,644) (2,093) (20,674) (47,541) (110) (255) Total estimated exposure 552,373 846,668 419,250 204,972 805,888 2,829,151 18,698 34,421 Estimated Basel III Tier 1 leverage ratio 4.3% 3.7% 3.7% 3.4% 3.9% 3.8% 8.1% 3.5% (1) Tier 1 capital on a reported "all-in" basis, which assumes that Basel III regulatory adjustments are applied effective January 1, 2013 and that the capital value of instruments which no longer qualify as regulatory capital under Basel III rules will be phased out at a rate of 10% per year from January 1, 2013 and continuing to January 1, 2022. (2) Non-credit derivatives are calculated at replacement cost, including the full impact of netting agreements. According to the Basel Committee, written credit derivatives can be netted with purchased credit protection if the reference entity and seniority of claim is the same. Given limited disclosure on the reference entities and seniority of claims, written and purchased credit derivatives are presented at notional value without the benefit from netting. (3) Potential future credit add-on calculated as the credit equivalent amount (non-credit derivatives) less the replacement cost (non-credit derivatives). The Basel Committee has not disclosed how the future potential add-on will be calculated. (4) Off-balance sheet exposure calculated as unconditionally cancellable commitments multiplied by a 10% credit conversion factor (CCF) plus other off- balance sheet exposures multiplied by a 100% CCF, as proposed by the Basel Committee. Source: Company reports, RBC Capital Markets estimates

The Tier 1 leverage ratio (Tier 1 capital to total exposure48) will be introduced globally by the BCBS as a leverage constraint to supplement its risk-weighted capital requirements.

48 Total exposure is the denominator in the Tier 1 leverage calculation and comprises on-balance sheet exposures, derivative exposures, securities financing exposures, and other off-balance sheet exposures. September 18, 2013 180 Canadian Bank Primer, Sixth Edition

Leverage constraints proved to be useful checks in 2007–2009 against risk-weighted capital methodologies, which severely underestimated the risks in certain products and lines of business. The methodology proposed by the BCBS to calculate leverage will be different from OSFI’s methodology (discussed later in this section).

 The targeted minimum Tier 1 leverage ratio will be 3% for its testing or parallel-run period, and the netting of derivatives in the calculation will be allowed. Adjustments to the design and calibration of the leverage ratio, including the 3% minimum, could change before final implementation, which is targeted for January 2018. We estimate Tier 1 leverage ratios (with netting of derivatives) to range from 3.4% at National Bank to 4.3% at Bank of Montreal, which is well above the 3% minimum.  The losses that hit banks in 2007 and 2008 generally hit in areas that attracted low-risk weightings, so risk-weighted ratios proved to be imperfect. Risk was particularly underestimated in the following areas: holdings of structured finance assets; credit and liquidity risk in trading books; and exposure to off-balance sheet vehicles. The banks in countries that were supervised on more than just risk-weighted ratios (such as Canada, where banks are also subject to an assets-to-capital constraint) found themselves in fairly better health than in some other countries, particularly European countries, because the leverage constraints proved to be a useful check against risk-weighted capital methodologies, which severely underestimated the risks in certain products and lines of business.  We believe that leverage ratios will be a secondary tool for regulators because risk- weighted methodologies are conceptually superior, in our view, especially since regulators have strengthened/are strengthening the calculation of risk-weighted assets and capital. A leverage calculation is conceptually overly blunt as a measure of leverage because hedged or insured books are unduly penalized, and it does not differentiate between risky assets (which should be backed by a lot of capital) and less risky assets (which would require less capital). For example: 1) not all assets have the same risk (e.g., an AA-rated loan would have much less risk than a B-rated loan, or a mortgage would have much less risk than a credit card loan, yet they would count equally in a leverage test); 2) products with embedded leverage (such as derivatives and holdings of low- rated structured products tranches) count equally as unlevered products; and 3) many assets on Canadian banks’ balance sheets have very little risk, in our view, including insured mortgages, and government securities, but also repos, uninsured mortgages, and government-backed securities.

Exhibit 149: Capital and leverage ratios – Estimated Tier 1 leverage is lowest at Bank of Montreal; highest at National Bank

Reported Regulatory Capital Ratios ("All-in")* Big Six (At Q3/13, in $millions) BMO BNS CM NA RY TD Total CWB LB Common Equity Tier 1 Capital 20,627 25,118 12,483 5,235 29,048 25,353 117,864 1,244 1,014 Tier 1 Capital 23,986 31,041 15,578 6,972 35,702 31,077 144,356 1,516 1,219 Total Regulatory Capital 28,838 38,948 19,661 9,198 43,180 40,224 180,049 2,194 1,701 Risk Weighted Assets 214,233 282,309 133,994 60,895 314,804 283,521 1,289,756 15,846 13,472 Common Equity Tier 1 Ratio 9.6% 8.9% 9.3% 8.6% 9.2% 8.9% 9.1% 7.8% 7.5% Tier 1 Capital Ratio 11.2% 11.0% 11.6% 11.4% 11.3% 11.0% 11.2% 9.6% 9.0% Total Capital Ratio 13.5% 13.8% 14.7% 15.1% 13.7% 14.2% 14.0% 13.8% 12.6% Assets-to-Capital 16.2x 17.1x 18.1x 18.0x 16.8x 17.7x 17.4x 8.0x 17.2x Estimated Basel III Tier 1 leverage ratio 4.3% 3.7% 3.7% 3.4% n/a 3.9% 3.8%** 8.1% 3.5%

*“All-in basis” assume that all Basel III regulatory adjustments are applied effective January 31, 2013 and that the capital value of instruments which no longer qualify as regulatory capital under Basel III rules will be phased out at a rate of 10% per year from January 31, 2012 and continuing until January 1, 2022; ** Excludes RY. Source: Company reports, RBC Capital Markets estimates

Common equity-to-assets is a simple way for a shareholder to measure ROE in relation to balance sheet leverage. Measuring margins earned on balance sheet assets, as well as the September 18, 2013 181 Canadian Bank Primer, Sixth Edition

equity-to-assets ratio, provides a better understanding of where ROE changes come from (margins compared to leverage).

 As discussed above, this calculation is conceptually overly blunt as a measure of leverage because hedged or insured books are unduly penalized, and it does not differentiate between risky assets (which should be backed by a lot of capital) and less risky assets (which would require less capital).  Balance sheet leverage at Canadian banks has been reduced since the early 1980s, as Exhibit 151 shows. From 2003 to 2007, there was a mild increase in leverage, which helped to drive up ROE somewhat (higher ROA was a more significant factor in rising ROE). Leverage has since come down, which is the main reason why our 2014/2015 forecast ROEs are lower than 2003-2007.(Exhibit 151)  As is the case for the other capital measures that we discuss, we would first look at the common equity Tier 1 ratio and then use the Tier 1 leverage ratio to “break ties”.

Banks are also subject to the assets-to-regulatory capital constraint that is currently imposed by OSFI (Exhibit 150). It is measured as total assets plus specified off-balance sheet items divided by total regulatory capital. The regulatory limit for the assets-to-capital multiple is 20x and can go up to 23x with OSFI’s prior approval.

Exhibit 150: Assets-to-regulatory capital has declined from 2007-2008 and is capped at 20x*

Assets to Regulatory Capital

Assets-To-Capital Basel I Basel II Basel III Multiple (ACM) Q4/07 Q4/08 Q1/09 Q2/09 Q3/09 Q4/09 Q1/10 Q2/10 Q3/10 Q4/10 Q1/11 Q2/11 Q3/11 Q4/11 Q1/12 Q2/12 Q3/12 Q4/12 Q1/13 Q2/13 Q3/13 Bank of Montreal 17.2x 16.4x 15.8x 15.4x 14.9x 14.1x 14.7x 14.2x 14.3x 14.5x 14.8x 13.7x 14.3x 13.7x 15.4x 15.1x 15.8x 15.2x 16.1x 16.3x 16.2x Scotiabank 18.2x 18.0x 18.1x 17.3x 16.6x 16.6x 16.8x 17.7x 17.1x 17.0x 17.6x 17.6x 17.0x 16.6x 17.7x 17.5x 17.2x 15.0x 17.3x 17.5x 17.1x CIBC 19.0x 17.9x 17.7x 16.6x 16.2x 16.3x 16.1x 15.3x 16.6x 17.0x 17.6x 18.2x 16.8x 16.0x 16.7x 17.0x 17.4x 17.4x 17.9x 18.0x 18.1x National Bank 18.6x 16.7x 16.4x 17.1x 16.1x 15.4x 15.5x 17.0x 16.5x 15.9x 16.3x 17.1x 17.2x 17.2x 19.5x 17.5x 17.8x 18.3x 18.7x 18.3x 18.0x Royal Bank 19.9x 20.1x 17.5x 16.3x 16.3x 16.3x 16.2x 16.0x 16.5x 16.5x 16.5x 16.3x 16.4x 16.1x 16.6x 16.8x 16.7x 16.7x 16.2x 16.6x 16.8x TD Bank 19.7x 19.3x 16.9x 17.1x 16.6x 17.1x 17.6x 17.5x 17.4x 17.5x 17.1x 16.9x 17.4x 17.2x 18.3x 18.1x 18.3x 18.0x 17.6x 17.7x 17.7x Median 18.8x 18.0x 17.2x 16.9x 16.3x 16.3x 16.2x 16.5x 16.6x 16.8x 16.8x 17.0x 16.9x 16.4x 17.2x 17.3x 17.3x 17.1x 17.5x 17.6x 17.4x

Canadian Western Bank 9.0x 9.2x 9.3x 8.2x 8.0x 8.1x 8.2x 8.4x 8.3x 8.5x 7.3x 7.3x 7.3x 7.9x 8.3x 9.0x 8.6x 8.8x 7.9x 8.0x 8.0x Laurentian Bank 15.8x 17.0x 17.1x 17.3x 17.8x 18.0x 18.6x 18.3x 18.4x 17.7x 16.1x 16.4x 16.2x 16.2x 18.0x 18.1x 18.7x 16.3x 16.8x 17.4x 17.2x

* The regulatory assets-to-capital multiple can go up to 23x with OSFI’s prior approval. Source: Company reports, OSFI, RBC Capital Markets

Exhibit 151: Higher leverage usually drives higher ROE, but relationship is not as strong as ROA

ROE vs. ROA Return on Equity vs. Leverage (Annual since 1970) (Annual since 1970) Correlation Coefficient: 0.93 Correlation Coefficient: 0.18 30% 1.1% 5.0% 40.0%

35.0% 25% 0.9% 4.5% 30.0% 20% 0.7% 25.0%

15% 0.5% 4.0% 20.0%

10% 0.3% 15.0%

3.5% 10.0% 5% 0.1% 5.0% 0% -0.1% 3.0% 0.0%

-5% -0.3% (5.0%)

2.5% (10.0%) -10% -0.5% 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 Common equity /Assets (LHS) Reported Cash ROE Cash ROE (LHS) Cash ROA (RHS)

As of Q2/13, the median of Big Six Banks (BMO, BNS, CM, NA, RY, and TD). Reported cash ROE and ROA include special items and exclude preferred dividends, goodwill, and intangibles. Source: Company reports, RBC Capital Markets

Non-common forms of regulatory capital are also core elements of the capital regime under Basel III. These instruments will be distinct from pre-Basel III iterations of non- common capital as they are now required to absorb losses on an ‘expectation of insolvency’, September 18, 2013 182 Canadian Bank Primer, Sixth Edition

rather than in the ‘event of insolvency’. However, as the first line-of-defence against unexpected loss, common equity investors will likely continue to view non-common forms of capital as a secondary consideration.

 Common equity capital requirements are designed to establish loss absorption capacity for unexpected loss on a ‘going-concern’ basis. In thinking of a bank’s capital structure, common equity capital, through retained earnings, is the first line of defence against unexpected loss. Giving effect to all minimum common equity requirements (i.e. including the capital conservation buffer and the D-SIB requirement) we expect the large banks will hold common equity capital equivalent to 8.5-9.0% of risk weighted assets.  Under Basel III, banks are also required to hold capital that is designed to absorb loss on an expectation of insolvency – a.k.a. NVCC. Banks have always been required to establish capital buffers to supplement prudent levels of common equity capital. However, practically speaking, pre-Basel III forms of non-common capital were only capable of absorbing loss in the ‘event of insolvency’ – this was due to inflexibility on coupon cancellation, an inability to write-down principal and execution challenges. While such capital was loss absorbing in theory, the financial crisis highlighted that a loss absorption threshold of ‘insolvency’ was impractical for a systemically important bank. Accordingly, Basel III requires that all forms of non-common capital must be loss absorbing on an ‘expectation of insolvency’ – that is, at the stage where regulators believe the institution ‘has ceased, or is about to cease, to be viable’. Such non-common capital is referred to as non-viability contingent capital, or NVCC.  OSFI has established a minimum 9.5% Tier 1 capital requirement under Basel III. The 9.5% Tier 1 requirement is comprised of a minimum 8% CET1 (inclusive of the capital conservation buffer and D-SIB surcharge), plus Tier 1 NVCC of up to 1.5%. As of January 1, 2013, in order to qualify as capital under Basel III, any newly issued Tier 1 capital instrument is required to have NVCC language, allowing for the conversion of the securities into common equity at the point of non-viability (as determined by the Superintendent). As in the past, non-common Tier 1 capital instruments will be comprised of innovative capital instruments (i.e. hybrids) and preferred shares. Canadian banks currently have approximately $28 billion of preferred share and hybrid capital outstanding, only $881 million of which is qualifies as permanent Tier 1 capital under Basel III (CIBC revised three preferred share issues to be NVCC compliant). Legacy Tier 1 capital instruments are receiving transitory capital treatment but will need to be replaced as they are eventually called and redeemed.  OSFI has established a minimum 11.5% Total capital requirement under Basel III. The 11.5% Total capital requirement is comprised of the Tier 1 minimum outlined above, plus Tier 2 NVCC of up to 2%. As of January 1, 2013, in order to qualify as capital under Basel III, any newly issued Tier 2 capital instrument is required to have NVCC language, allowing for the conversion of the securities into common equity at the point of non- viability (as determined by the Superintendent). As in the past, the banks will issue subordinated debt as a form of Tier 2 capital. Canadian banks currently have approximately $32 billion of Tier 2 capital outstanding, none of which is qualifying capital under Basel III. Legacy Tier 2 capital instruments are receiving transitory capital treatment but will need to be replaced as they are eventually called.  The banks have not yet priced an NVCC instrument in a market offering, however we expect the cost will be higher relative to legacy securities. Given the regulator’s ability and explicit willingness to convert these securities at a point of non-viability, we expect the cost of such capital will be higher than existing forms of non-common capital. However, we also expect the banks will issue less non-common capital than they historically have, thereby offsetting some of the additional cost.

September 18, 2013 183 Canadian Bank Primer, Sixth Edition

The Canadian government intends to enhance its capacity to resolve a systemically important bank failure through a senior debt ‘bail-in’ regime, in addition to improving the loss absorbency of regulatory capital as described above.

 Introducing a ‘bail-in’ regime would allow for the conversion of certain senior debt obligations into regulatory capital. Bail-in debt is distinct from NVCC by virtue of the fact that it is not regulatory capital at the outset, but rather a form of bank funding in a going concern state. However, it differs from our conventional understanding of bank funding as it represents a senior ranking liability that could be converted into equity at the point of non-viability (likely, as determined by the Superintendent).  At this stage there is no formal bail-in requirement as the government is studying various approaches for implementation. Our understanding is that there are currently two bail-in strategies that are under consideration. A ‘Statutory’ approach would grant the government legal conversion authority over senior unsecured obligations as deemed necessary / appropriate. Alternatively a ‘Contractual’ approach would require institutions to hold a minimum (based on risk weighted assets) cache of senior debt instruments that are explicitly subject to bail-in provisions. At this stage there is no clarity with respect to which approach the government will adopt, although we expect a contractual approach is favoured on the part of OSFI.  A bail-in regime should increase the cost of funding, although the extent of the increase is uncertain. While the cost of bail-in debt is only theoretical at this stage, we would expect that under a Contractual approach the cost of issuing ‘bail-in’ senior debt will be higher than the current cost of senior unsecured debt. Alternatively, under a Statutory approach the cost of funding should theoretically increase for all senior unsecured debt.

Economic and rating agency capital requirements matter We believe that meeting regulatory capital hurdles is the number one priority for banks, but economic capital and rating agency capital constraints also influence how much capital banks hold.

Economic capital typically includes a broader definition of risks than regulatory capital, incorporates goodwill and intangibles, and considers diversification benefits across risk and business segments.

 Additional risk considerations can include normal risks of staying in business, such as the risk of price changes based on competitive forces, and reputational issues or the possibility that fixed-asset values will decline below book values.  The benefit of business, product, and geographic diversification on economic capital is one of the major differences from regulatory capital. Well diversified banks are less likely to see all businesses perform poorly at the same time, so if one or a few businesses lose money, then income from other businesses keeps the bank from falling into a loss position and depleting capital. Therefore, economic capital theory would have a well diversified bank hold less capital than one that is more narrowly focused.  Banks also use economic capital to measure performance across divisions based on the returns on attributed capital (with riskier businesses being allocated more capital) and to make strategic investment-allocation decisions. Divisional returns on economic capital may not be comparable across banks since different assumptions and methodologies are used.

September 18, 2013 184 Canadian Bank Primer, Sixth Edition

Banks also tend to target rating-specific agency ratings because they influence some of their cost of funds.49 Accordingly, banks also determine how much capital to hold based on their perception of what may lead to a certain debt agency rating. In analyzing bank credit, rating agencies review a number of factors, of which capital adequacy is one. They also consider strategy and management strength, credit and market risk, funding and liquidity risk, diversification, and earnings performance. Rating agencies may also have different definitions of capital than regulators and may not all agree on relative risk profiles (Exhibit 152

Exhibit 152: Bank credit ratings

As of August 31, 2013 Senior Debt Bank DBRS Moody's S&P Fitch Bank of Montreal AA Aa3 A+ AA- Bank of Nova Scotia AA Aa2 A+ AA- CIBC AA Aa3 A+ AA- National Bank of Canada AA (Low) Aa3 A A+ Royal Bank of Canada AA Aa3 AA- AA Toronto-Dominion Bank AA Aa1 AA- AA- Source: Rating agencies, RBC Capital Markets

Not all banks should have the same capital levels The previous sections dealt with capital from a balance sheet and risk perspective. Income capacity needs to be considered when determining ideal capital requirements because banks that generate higher and more stable income relative to risks theoretically should not hold as much capital.

We consider capital as the “second line of defence” against the cost of unexpected risks, with the “first line” being income generation (Exhibit 154). Banks that generate higher income relative to the risks taken theoretically do not need to hold capital ratios that are as high as other banks. Also, banks with less volatile earnings stream (that may come from a diverse set of negatively correlated businesses) would not be expected to hold as much economic capital, in our view. The analysis in Exhibit 153 is not how regulators determine capital requirements, but an analyst can again break ties for banks with similar regulatory capital ratios by looking at the following two metrics:

 Historical returns on risk-weighted assets. Banks that earn higher returns on risk- weighted assets are doing so by taking less risk and, therefore, should be less exposed to the risk of an “income” event becoming a “capital event” since income is generated from less risky assets.  Historical loan losses relative to pre-tax, pre-provision income. Credit risk is the largest risk for banks, accounting for 80% of capital requirements. Banks that generate higher profits before taxes and loan losses have a greater ability to handle unexpected credit hits with income generation rather than with capital.

49 The differences in cost of funds are felt more in medium-term wholesale funding. Cost of funds today have converged (e.g., 5-year senior deposit notes would be about 104 basis points for BMO, BNS, CM, RY and TD, and at~ 106 bps for NA) but have been 10 to 20 basis points wider from each other when capital markets were unstable. Canadian banks have similar cost of funds for retail deposits and short-term institutional funding. September 18, 2013 185 Canadian Bank Primer, Sixth Edition

Exhibit 153: Banks with higher RoRWA and less exposure to loan losses relative to income need less capital

BMO BNS CM NA RY TD Median Common equity Tier 1 ratio Q3/13 9.6% 8.9% 9.3% 8.6% 9.2% 8.9% 9.1% Assets to regulatory capital Q3/13 16.2x 17.1x 18.1x 18.0x 16.8x 17.7x 17.4x

RORWA (reported cash) Q3/13 2.0% 2.3% 2.6% 2.5% 2.7% 2.4% 2.5% RORWA (core cash) Q3/13 2.9% 3.4% 4.4% 3.6% 4.1% 3.9% 3.7% RORWA (core cash) 5-yr Median 1.6% 1.9% 2.3% 1.9% 2.3% 2.6% 2.1%

(Pre-tax, Pre-Provision Income) / Loan Losses YTD 10.7x 7.5x 4.6x 12.9x 9.9x 6.1x 8.7x 5-yr Median 4.4x 6.9x 4.0x 10.5x 7.3x 4.9x 5.9x 10-yr Median 7.2x 7.8x 4.2x 10.1x 8.6x 5.9x 7.5x

Source: Company reports, RBC Capital Markets

Exhibit 154: Income is the first line of defence against loan losses

Provisions for credit losses to Pre-tax pre-provision earnings

70%

60%

50%

40%

30%

20%

10%

0% 90 92 94 96 98 00 02 04 06 08 10 12 14E

PCL to Pre-tax pre-provision earnings

Source: Company reports, RBC Capital Markets estimates

Expected changes to regulatory requirements In the upcoming section, we discuss changes that have been proposed but will likely change: 1) the introduction of requirements for liquidity risk; and 2) the introduction of a buffer for counter cyclicality (which would promote the build up of capital in times of rapid loan growth). Liquidity and countercyclical buffers The BCBS’s rules and proposals include areas where we are not able to quantify the effect at this time because: 1) banks’ disclosures make it nearly impossible for outsiders to do so, in our view; and 2) the rules are in the process of being finalized.

September 18, 2013 186 Canadian Bank Primer, Sixth Edition

Liquidity requirements to be introduced; implementation will be lengthy The BCBS will introduce global standards for liquidity,50 which did not exist on a Canadian or global basis in the past, or in the Canadian regulatory regime. The introduction of requirements for liquidity reflects the 2007–2008 “reminders” to regulators and market participants that theoretically solvent institutions can fail in an environment of reduced or vanished confidence. More cautious liquidity management generally leads to greater holdings of cash and short-term securities and/or more holdings of government securities, both of which hurt margins, in our view. It can also lead to lower risk in that the duration of assets and liabilities is more closely matched by extending the term of liabilities, which lowers risk but can also reduce margins in a steep yield-curve environment.

For greater detail on liquidity rule changes, please see our report “Canadian Banks – Liquidity rules are directionally negative for profitability” published November 7, 2011.

Key elements of the liquidity requirements include: 1) a liquidity coverage ratio that would ensure that banks have enough liquid assets to survive a stressed 30-day period with no access to outside funds; and 2) a net stable funding ratio that would lead to lower duration mismatches between assets and liabilities primarily by leading to banks extending the term of their liabilities.

The new requirements will be phased in over an extended period. The liquidity coverage ratio will be introduced in 2015 and the net stable funding ratio in 2018, but we believe that OSFI, based on its prior track record of implementing global regulation early, could push Canadian banks to adopt some of the liquidity proposals earlier. In fact, some of the behaviours we are observing are indicative of banks already being more conservative in their liquidity risk management, including more competitive pricing for retail term deposits, reductions in off balance sheet commitments, greater holdings of liquid assets, and extension of term when funding wholesale. BCBS published updated guidelines to its liquidity coverage ratio in January 2013, which we view as positive for the Canadian banks, as the rules were somewhat loosened. The changes that were made had to do with what could be included in the stock of high quality liquid assets (HQLA), the haircuts which are to be applied to certain assets, such as equities and a graduated approach to compliance with the LCR by 2019 was introduced to ensure that the LCR can be introduced without material disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity.

The new rules on liquidity will reward banks with more retail and/or relationship customers, funding durations that match asset durations, more liquid assets, and low- potential contingent calls on liquidity. Businesses that would be negatively affected by the current proposals broadly include any commitment of credit or liquidity, securitization businesses, equity total return swaps, and certain market-making businesses.

Banks will forever be exposed to liquidity risk, because the lending business is generally a longer duration than the duration of deposits, some of which can be “called” by depositors on short notice. There is arguably a social good coming out of banks’ willingness to take on liquidity risk because it creates funding or capital for businesses and individuals to invest in longer-term assets. The recognition of this important social benefit is why governments and central banks will likely support the provision of emergency liquidity to regulated institutions

50 Liquidity risk refers to an institution’s potential inability to access cash in a timely and cost-effective manner to fund obligations. A “run” on a bank can bankrupt it even if the credit quality of its assets is in good shape or capital ratios look healthy (Northern Rock, Bear Stearns, and Lehman Brothers are examples of firms that technically failed because their access to funding dried up, not because they incurred losses on assets that bankrupted them). September 18, 2013 187 Canadian Bank Primer, Sixth Edition

as well as the creation and maintenance of deposit guarantees. Many of the worst-hit institutions in 2007 and 2008 were unregulated and did not have access to emergency funding or benefit from guarantees (structured investment vehicles, for example).

While regulators recognize the banks’ social role in providing long-term capital to borrowers, their primary responsibility is the safety and soundness of the banking system, and we believe that the events of the 2007-2009 period have led to regulators placing increased emphasis on liquidity-risk management. Liquidity risk has always been viewed as important by regulators, but we believe that liquidity and funding issues exacerbated the credit and market-related challenges that banks had been facing worldwide. As governments around the world moved to shore up banks’ access to liquidity (by raising deposit guarantees or backing the issue of bank debt, for example), concerns over liquidity and funding declined compared to 2007 and 2008. The measures that governments took are probably measures that they do not want to undertake again (and in some cases, cannot afford to), and as a result, rules on liquidity management will be introduced, which is likely to result in higher holdings of shorter-term, lower-risk securities, and cash-like instruments.

Institutions that have liquidity challenges typically have some of the following characteristics: 1) mismanagement of asset-liability duration can leave a bank unable to fund assets if short-term funding becomes unavailable, or it can lead to a rapid squeeze in margins if short-term rates move up but not medium or long-term rates; 2) concentration of funding sources, which can leave a bank in trouble if its key funding relationships dry up, even if underlying assets are of good quality; 3) a balance sheet heavily concentrated in illiquid assets or assets that may suddenly become illiquid; 4) overreliance on short-term sources of funds; 5) loss of confidence in a bank’s assets; and 6) off-balance sheet guarantees becoming on-balance sheet commitments.

Banks least likely to run into funding or liquidity risks are those that: 1) closely match the duration of their assets and liabilities; 2) fund their assets with mostly retail deposits, particularly chequing and savings accounts; 3) assume conservative haircuts on securities (i.e., how much they could realistically sell assets for if they needed to be rapidly liquidated); 4) maintain access to diversified sources of both retail and wholesale funding; and 5) hold excess cash and liquid securities, which could be liquidated to fund obligations if necessary.

We believe that the new liquidity rules will be negative for bank profitability relative to 2003-2007, all else equal, particularly for banks larger in capital markets and for banks with lower proportions of retail funding. Given that available disclosures do not allow outsiders to accurately calculate Liquidity Coverage and Net Stable Funding ratios, the still early stage of some of the proposals, banks having had time to prepare for the implementation, and the probable management actions (i.e., the repricing of some products, changes to some products and business mix changes), it is difficult to come to absolute conclusions on how much the industry will be affected. However, we can fairly comfortably say that the rules will likely lead to lower net interest margins over time, and that TD Bank will be less impacted given its smaller capital markets businesses and less reliance on wholesale funding, in our view.

 The rules are directionally negative for bank profitability relative to the 2003-2007 period in the following ways: (1) they will likely lead to banks holding more liquid assets, including government-issued debt rather than bank-issued or corporate bonds, which is directionally negative for margins; (2) banks will likely reduce certain wholesale assets and off-balance sheet commitments, which is directionally negative for profitability (although banks will pass on some of the higher costs of meeting the new liquidity rules to customers); (3) they will likely increase competition for retail deposits,

September 18, 2013 188 Canadian Bank Primer, Sixth Edition

which is directionally negative for margins; and (4) they will likely push banks to extend the term of their liabilities, which is directionally negative for margins given that the yield curve is normally steep. The effect of these changes will be magnified if banks worldwide attempt to accomplish similar objectives at the same time and we would note that many of these “expected behaviours” have been observed in recent years.  Banks with larger retail deposit franchises and smaller wholesale businesses, such as TD Bank, are better positioned than others to meet the new standards with less impact on profitability, in our view. Capital markets businesses will be most negatively affected by the liquidity rules, in our view, as: (1) wholesale assets and contingent liabilities will be subject to harsher liquidity assumptions than we believe banks are currently using under their own liquidity coverage tests; and (2) wholesale assets are generally funded more with wholesale deposits than retail deposits, and wholesale deposits have more punitive outflow assumptions in liquidity coverage tests. Duration of liabilities will also likely be a key differentiator between banks: those funded at a term shorter than the term of their assets will have to extend the term of their funding (which will increase funding costs), although it is difficult to identify which Canadian bank is more or less affected by this last item.

The Liquidity Coverage Ratio (LCR) helps ensure that banks have enough liquid assets to survive a stressed period of time with no access to outside funds. In other words, if a bank’s access to incremental outside funding disappeared for 30 days and less “sticky” deposits were withdrawn, a bank must have enough resources (i.e., liquid assets) to survive. The value of a bank’s liquid assets must be at least as large as net cash outflows under a stressed scenario over a 30-day period.

 As banks move to align themselves with the LCR standard, we expect: (1) increased holdings of short-duration and high quality liquid assets; (2) the reduction of certain wholesale assets (particularly those with low liquidity value such as certain bank debt, equities, and poorly rated credit) and off-balance sheet commitments such as asset- backed commercial paper liquidity lines and undrawn credit commitments, although we believe that banks will attempt to pass on some of the higher costs of meeting the new liquidity rules to customers; and (3) increased competition for retail deposits, which should have higher “value” under liquidity tests as they are assumed to be stickier than other types of deposits.  Some of the behaviours we have observed are indicative of banks already being more conservative in their liquidity risk management, including more competitive pricing for retail term deposits, reductions in off balance sheet commitments, greater holdings of liquid assets, and extension of term when funding wholesale. (For examples of these trends, please see our report “Canadian Banks – Liquidity rules are directionally negative for profitability” published November 7, 2011).

The Net Stable Funding Ratio (NSFR) helps determine which banks over-rely on short-term funding, and alignment will likely lead many banks to seek longer-term funding profiles with lower asset duration mismatches. The stable funding that a bank has available must be higher than funding required under a stressed one-year period. Available stable funding consists of bank capital, longer-term debt, and core deposits. Required stable funding depends on cash flows of on- and off-balance sheet exposures or business activities.

 The Net Stable Funding Ratio will likely lead to a reduction in duration mismatches for the funding of medium- and long-term assets as banks look to issue longer-term funding than they have in the past in wholesale funding, which over time reduces liquidity risk but is costlier. Canadian banks have been using more diverse term funding options and issuing debt farther out the curve in recent years, which indicates that they are at the September 18, 2013 189 Canadian Bank Primer, Sixth Edition

margin better prepared for when the rules will be implemented. It is not as easy to differentiate the banks for the Net Stable Funding Ratio as it is for the Liquidity Coverage Ratio, although it is fair to say that banks less dependent on wholesale funding would likely be less impacted.  While the NSFR is very likely to change between now and implementation in 2018, Canadian banks have been issuing longer-term debt in recent years, which leads to closer asset duration matches. For example, Canadian banks have issued about $35 billion of covered bonds51 since 2010 versus $12 billion in prior years, and over $7 billion of syndicated NHA/MBS bonds52 since they were introduced in October 2009. It is more difficult to differentiate the banks’ positioning ahead of the implementation of the NSFR than it is for the LCR. However, the LCR is a more important issue for investors near term, in our view, given that regulators are initially more focused on the LCR. The NSFR is still likely to change with implementation years away.

Countercyclical capital buffers could be introduced Basel III capital rules include a countercyclical capital buffer, which could add to minimum target ratios in periods of rapid credit growth (and are withdrawn in periods of slow credit growth). It is not clear, however, how OSFI will determine when a buffer should be applied and how large it should be. The BCBS has given guidance of 0–2.5% as a potentially additional buffer to target minimum ratios, which can be added or withdrawn at the discretion of national regulators.

We believe that the purpose of this buffer is twofold: 1) periods of rapid credit growth are often followed by increased losses, so this buffer would strengthen balance sheets ahead of losses; and 2) the elimination of the buffer in stressed environments would help banks’ ability to continue lending even if loan losses negatively affect capital and increased probabilities of default push risk-weighted assets higher. The BCBS has proposed using private-sector credit to GDP as a guide when determining whether credit growth is too rapid (if it is above trend); however, local regulators would have discretion as to what metrics to use in determining whether loan growth is too rapid or not, and as to the size of the buffer that would be required in the event that loan growth were too rapid. Implementation, therefore, is likely to be inconsistent across borders but consistent within borders because we believe host regulators would take the lead in setting countercyclical buffers.

The countercyclical buffer will likely be gradually implemented starting 2016 and become fully effective in January 2019.

51 Covered bonds are full recourse on-balance sheet obligations that are full collateralized by assets by which investors have a priority claim in the event of issuer insolvency. They were first issued by Royal Bank in late 2007, followed by Bank of Montreal in early 2008. 52 National Housing Act Mortgage Backed Securities are guaranteed by CMHC on behalf of the Government of Canada. CMHC introduced Canadian NHA MBS in 1987 to provide all investors an opportunity to invest in Canadian residential mortgages, which helps to increase the supply of low-cost funding for mortgage lending. September 18, 2013 190 Canadian Bank Primer, Sixth Edition

SECTION 9: Valuation – Metrics to track and when to buy (or not) The valuation section covers: 1) the three main valuation metrics that are used for banks (price-to-earnings, price-to-book, and dividend yields); 2) when it is time to buy banks (or not); 3) why we think banks should trade at higher valuations than in the 1990s, but not as high as in the 2003 –2007 period; and why we believe higher interest rates would be good for banks. Price-to-earnings valuation is most commonly used The most commonly used method to value banks is price-to-earnings (P/E). Banks have traded in an 8–14x P/E range (based on forward earnings) in the last 10 years (the average was 11.4x). Fluctuations within the 8–14x range are driven by:

 Earnings visibility and expected growth, which tend to be highest in times of economic strength;  Capital markets buoyancy as healthier markets increase growth rates of wealth management and capital markets businesses; and  Expectations for interest rates, although correlations can change depending on interest rate levels. Lower interest rates normally drive P/Es higher unless they are so low that they reflect worries over a potential deflationary environment, which would be a very negative environment for financial services companies.53 In the current environment, we believe that higher interest rates would be positive for banks.

The following attributes generally lead to banks trading at higher P/E ratios relative to their peers:

 Higher and more visible prospects for earnings growth;  Perceived quality of earnings (securities gains, trading revenues, securitization gains when they existed under CGAAP, and “other” earnings are often discounted given their opaque and unpredictable nature);

53 An extended or severe deflationary environment would be very painful for the banking sector, in our view, as it would lead to squeezed net interest income margins, greater loan defaults, and much lower loan demand. Equity market-linked businesses would also be negatively impacted.  We believe that the resulting interest rate environment would challenge net interest income margins in many ways: (1) low short term rates would make it difficult to earn attractive rates of return on short term deposits; (2) low long term rates and borrowers that lack confidence are not conducive to banks charging high spreads on loans; and (3) the flat yield curve would take away the possibility of establishing carry trades. Near term, banks that borrow short to finance long-term assets would see a benefit to their net interest income margins but that benefit would disappear as assets matured.  Loan losses would increase in our view. (1) Corporate and commercial customers that cannot reduce their costs fast enough to adapt to lower revenues could fail. (2) An increase in unemployment would lead to an increase in consumer defaults. (3) Lower asset values would lead to lower recoveries on collateralized lending, which would be particularly relevant for residential and commercial real estate lending.  Defined benefit pension plan liabilities would increase. The combination of the impact of lower equity values on invested assets and reduced discount rate on liabilities would have a negative material impact on future defined benefit liabilities.  Weak equity markets would reduce the profitability of asset management and wealth management businesses and challenge segments of capital markets businesses. Intuitively, trading activity would be subdued, to the detriment of retail and institutional brokerage businesses.  Loan growth would likely stall as loan growth is normally driven more by economic growth than by interest rate levels. In a deflationary environment, borrowers understand that they would be paying off future debt with more "expensive" dollars which would greatly reduce loan demand, in our opinion. Additionally, consumer and corporate borrowers alike would move aggressively to pay off loans recognizing the higher cost of debt in a deflationary environment. September 18, 2013 191 Canadian Bank Primer, Sixth Edition

 Business mix that is higher in wealth management, followed by traditional retail banking, followed by wholesale banking;  Balance sheet strength (well capitalized banks should trade at a higher P/E, if all else is equal);  Perceived quality of management; and  Comfort (or lack thereof) regarding potential capital deployment.

The Big Six banks have generally traded in a fairly narrow P/E range, with the gap between the most highly valued bank and the lowest valued bank typically in the 2–3x range, as shown in Exhibit 155. Based on 10-year averages, National Bank has traded at a lower multiple while Scotiabank and Royal Bank have traded at higher multiples, but we caution investors in using individual banks’ historical valuation without consideration of what might be different in the future. For example, for much of the early 2000s, Bank of Montreal traded at a premium multiple to the bank group, in part because it was perceived as being an acquisition target and in part because its loan book performed better in the credit downturn of the early 2000s. In the most recent recession, Bank of Montreal traded at a P/E discount to the group because investors did not believe that the larger Canadian banks were acquisition targets (and still do not), and the bank was more exposed to US credit woes given its exposure through its Harris subsidiary (Bank of Montreal is currently trading around the median of the big bank range). Ignoring changing dynamics and looking solely at historical valuations would have been a mistake in this case.

 The banks are more different today than in the past, in our view. Geographic sources of revenues are evolving differently, business mixes are not as homogenous as in the past, and performance within business lines can vary materially (domestic retail operations being a good example).  Long-term returns have not been as consistent as some may think. In the last 10 years, returns from holding the top-performing bank stocks (Canadian Western Bank, National Bank and TD Bank) and the lowest (Bank of Montreal and CIBC) have been quite different. The 10-year CAGR (including reinvested dividends) from holding Canadian Western Bank, National Bank and TD Bank has been 13%–15% compared to 8%–9% for Bank of Montreal and CIBC. Furthermore, returns can vary wildly on shorter-term horizons.  Valuations are unlikely to be as tight if Canadian investors increasingly invest on a global basis, which is likely, in our view, given the removal of foreign-investment limits for pension funds in early 2005 and recent underperformance of Canadian stocks relative to US stocks. We believe that limited investment opportunities for Canadian- focused investors have been a key contributor to historically tight valuations. The disparity between bank P/Es in the US, where investors have a broad set of banks to choose from, can be quite wide.

P/E ratios for the Canadian banks have risen in the last 30 years (Exhibit 155). This change can be explained by changes to business mixes, declining risk-free rates, improved capitalization ratios, rising ROE, and improved risk-management capabilities. P/E ratios arguably remain low given the banks’ ROE and track record of long-term earnings and dividend growth, but the banking system overall has long exhibited a cyclical profitability pattern (Exhibit 156), and the “accident years” typically scar investors and keep them from paying multiples that are as high as those of other industries with high ROE, solid long-term earnings, and dividend growth. The 2007–2009 period and European struggles in 2011 and 2012 reinforced global bank investors’ view that bank profitability is cyclical, in our view.

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 Canadian banks currently trade at a median forward P/E of about 10.4x, which compares to a five-year average of 10.7x, a 10-year average of 11.4x, and a 15-year average of 11.3x. We believe that bank P/Es will settle in the 11–12x range in a normal economic environment. The 11–12x range is closer to where banks have traded in the last decade than to where they had traded in prior decades because: 1) banks are better capitalized; 2) banks have more exposure to wealth management; and 3) ROE is higher. Those multiples are lower than what banks traded at in the last 10 years in periods of economic growth (they normally traded above the average in those periods), as we expect lower EPS growth than banks have typically delivered in periods of economic growth given a less accommodative backdrop for domestic consumer loan growth. Positively, while we believe that EPS growth will be lower than in the past, the banks are subject to stricter capital and liquidity rules, which should in theory be positive for risk premiums.

Exhibit 155: P/E ratios have risen since 1980; gap between highest and lowest P/Es is usually narrow

Forward P/E - Canadian Bank Index Forward P/E - Big Six Canadian Bank Range (Since 1980) (Since 1985) 16x 21% 20x

18x 14x 18% 16x 12x 15% 14x

10x 12% 12x

10x 8x 9% 8x

6x 6% 6x

4x 4x 3% 2x

2x 0% 0x 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Jun-85 Jun-87 Jun-89 Jun-91 Jun-93 Jun-95 Jun-97 Jun-99 Jun-01 Jun-03 Jun-05 Jun-07 Jun-09 Jun-11 Jun-13

Canadian Bank Index P/E NTM 10-Yr Canada Bond Max P/E forward Min P/E forward Difference

As of August 31, 2013. Canadian Bank Index. Source: RBC Capital Markets Quantitative Research

September 18, 2013 193 Canadian Bank Primer, Sixth Edition

Exhibit 156: Bank earnings growth can be volatile

Canadian Bank Index YoY Earnings Growth (Annual since 1957)

110%

90%

70%

50%

30%

10%

-10%

-30%

-50%

-70% 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Canadian Bank Index (Prior to 1980 includes banks and trusts). Source: RBC Capital Markets Quantitative Research, RBC Capital Markets

Most Canadian bank analysts focus on cash earnings as opposed to IFRS (or GAAP previously) earnings. The difference between the two figures relates to the amortization of intangibles because goodwill is no longer amortized. We believe that excluding those non-cash items (and to focus on cash earnings) is appropriate because: 1) they relate to cash outlays that have already occurred; 2) unlike depreciation related to hard assets, there is no spending required for “upkeep” of intangible assets; 3) non-cash items, such as goodwill impairments and the amortization of intangibles, do not impact the banks’ common equity Tier 1 ratio; and 4) if an acquisition is unsuccessful (which would suggest that goodwill and intangible assets may be overvalued), the cash earnings from that acquisition will not be strong, so the focus on cash earnings does not unfairly reward an acquisitive bank. The difference between cash and IFRS earnings is largest at TD due to several large acquisitions (Exhibit 157).

Exhibit 157: Cash earnings had been highest relative to reported at TD because of greater intangibles amortization

% Difference between Cash Earnings and IFRS Earnings (GAAP Earnings prior to 2011) Median 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Q3/13 2005-2012 BMO 4.6% 8.5% 5.4% 4.5% 3.7% 3.6% 1.4% 1.4% 1.6% 1.6% 1.2% 1.7% 2.5% 2.2% 1.6% BNS 1.6% 2.6% 1.3% 0.9% 0.5% 0.8% 0.7% 0.8% 1.2% 1.9% 1.7% 1.2% 1.2% 2.1% 1.2% CM 3.5% 3.8% 25.9% 1.1% 0.7% 0.3% 0.8% 1.0% 1.3% 1.6% 1.2% 0.9% 0.8% 0.4% 0.9% NA 4.8% 3.4% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.0% 0.0% RY* 3.9% 13.4% 2.4% 2.0% 2.0% 1.2% 1.6% 1.6% 2.2% 23.6%* 2.4% 1.9% 1.3% 1.4% 1.8% TD 58.2% 44.1% -274.4% 33.4% 24.9% 13.7% 10.8% 9.2% 10.5% 12.7% 10.1% 6.7% 3.6% 4.0% 10.3% Median 4.2% 6.2% 1.9% 1.5% 1.3% 1.0% 1.1% 1.2% 1.4% 1.8% 1.4% 1.4% 1.3% 1.7% 1.4%

A higher number reflects higher cash earnings (higher amortization of goodwill and intangibles) * Core cash earnings / core IFRS (or GAAP prior to 2011) earnings. Source: Company reports, RBC Capital Markets

September 18, 2013 194 Canadian Bank Primer, Sixth Edition

Analysts also consider core cash earnings in discussing quarters or upcoming years (i.e., cash earnings excluding unusual items). The purpose of looking at core cash earnings when analyzing a quarter is to have a sense of “earnings power” for a bank. Items typically excluded are gains or losses from sales of businesses, large acquisition and/or integration costs, unusual tax recoveries or assessments, non-cash adjustments to assets and liabilities, restructuring charges, the mark to market of CDS hedges for loans54 as well as banks’ own debt55, changes in general allowances56, and unusual litigation expenses. Banks that continually have reported earnings below core earnings typically trade at lower multiples of core earnings. We show in Exhibit 158 that one-off earnings items vary dramatically from bank to bank.

Exhibit 158: Reported earnings had been lower than core earnings from 2008 to 2011 and above in 2012

% Difference between Core Earnings and Reported Earnings Median 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Q3/13 since 2005 BMO 11.6% 16.5% -2.8% 0.2% 4.5% 7.2% 2.8% -25.6% -13.3% -24.3% 0.0% -3.4% 5.1% 2.2% -1.7% BNS 4.8% 2.8% -21.3% -0.4% 3.1% 0.7% 2.6% 0.8% -21.1% -2.7% 0.0% 6.0% 14.0% 5.8% 0.7% CM 25.8% -6.8% 137.6% 23.2% 1.8% -108.5% 8.7% 4.2% -191.0% -51.6% -9.9% -9.5% -1.9% -5.4% -9.7% NA 0.0% 0.4% -22.7% 0.0% 8.2% 7.0% 1.7% -44.0% -14.4% -20.8% -4.9% -3.7% 18.7% 7.7% -4.3% RY 0.0% 10.6% 0.0% 0.0% -7.3% -8.2% 2.0% 1.3% -18.6% -20.7% -1.8% 2.7% 0.8% 0.0% -0.5% TD -21.9% -10.3% -13.9% -32.9% 16.5% -12.0% 50.8% 4.2% -0.9% -23.9% -3.5% 0.1% -5.6% -0.1% -2.2% Median 2.4% 1.6% -8.3% 0.0% 3.8% -3.8% 2.7% 1.1% -16.5% -22.3% -2.7% -1.6% 3.0% 1.1% -1.9%

A negative number means a special loss, and a positive number means a special gain. Source: Company reports, RBC Capital Markets

We believe that divisional analysis is the best way to forecast Canadian banks’ earnings and that banks with more earnings coming from capital markets should trade at lower valuation multiples given higher earnings volatility. It is, however, important to reconcile divisional results with consolidated forecasts, and caution needs to be exercised when comparing different banks. There are many different and acceptable approaches to splitting revenues and costs among divisions (including the catch-all “corporate support” or “other” segment), and the banks do not allocate revenues and expenses the same way, and all banks will likely make changes to their methodologies over time. None of this affects consolidated results, but it has an effect on individual divisions’ results. For example, the allocation of treasury revenues and expenses varies from bank to bank, corporate overhead and central costs also are allocated differently, and the division of profitability of products that straddle divisions (mutual funds sold in branch networks for example) is also not consistent among banks.

54 Banks at times will use credit-default swaps to hedge some of their lending exposures (to reduce concentration risk to a certain issuer, for example). The accounting treatment of CDS requires a mark to market every reporting period while loans are not marked to market, which creates earnings volatility that is not reflective of economic reality. 55 Some banks have liabilities that are marked to market, which go up in value when secondary spreads on those banks widen. We think that giving banks earnings credit for widening spreads on their own debt is an irrational concept. At the extreme, a bank that is about to go bankrupt could in theory materially mark down its debt and as a result book an earnings gain, which would all be reversed if the bank’s financial health were to recover. 56 Some investors feel that general allowances (or allowances for loans not yet identified as impaired) are essentially reserves that cannot be used when banks have loans that go sour. We agree a little bit with the concept although we think that banks should have reserves for unanticipated losses and disagree that increases in general allowances for credit risk should be entirely ignored as a credit cost. September 18, 2013 195 Canadian Bank Primer, Sixth Edition

P/E ratios tend to be ignored in times of rising credit losses and deteriorating equity markets. In those conditions, bank earnings tend to deteriorate rapidly and generally come in below analyst expectations. It becomes more difficult to use P/E as a guide to near-term share price performance if investors do not have faith in estimated earnings. In a scenario where earnings estimates are declining (usually driven by weakening credit and/or weak equity and/or capital markets), investors tend to focus on the price-to-book (P/B) valuation methodology. Price-to-book valuation matters in uncertain times While we think that P/E is the most commonly used way to value banks in “normal times”, P/B multiples should not be ignored, and their importance increases when the earnings outlook is murky.

P/B multiples have risen in the last 20 years, as has been the case for P/E multiples for similar reasons. We generally find the measure less useful than it was in the past since banks’ balance sheets are not as important as they used to be in determining earnings power. This situation can be partly illustrated by looking at the evolution of revenue mix in the last 30 years; net interest income (which generally is balance sheet driven) declined to 45–50% of revenues in recent years from representing almost 80% of revenues in 1980.

Factors that can drive higher P/B multiples are similar to those that drive higher P/Es and include:

 Higher ROE (Exhibit 159);  Perceived quality of earnings (securities gains, trading revenues, securitization gains, and “other” earnings are often discounted given their opaque and unpredictable nature);  Balance sheet strength (well capitalized banks should trade at a higher P/B, with all else being equal);  Perception of management quality;  More visible earnings outlook; and  Quality of book value (banks with lower intangibles and goodwill balances should trade at higher P/B multiples, with all else being equal, compared to banks with higher balances).

Exhibit 159: Banks with higher ROE trade at higher P/B multiples

3.0x 4.0x CBA 2.5x 3.5x CBA WBC 3.0x WBCBK 2.0x ANZ CM NABUSB STT BNS TD CWBBNSTD NA USB FITB 2.5x ANZ NA BMO NAB CM 1.5x UBSN STT WFC NDA 2.0x WFCBBT CWB LLOYBBT FITB BMO PriceBook / UBSN KEYPNCGSFITBCSGN 1.0x BK BBVA JPM LB 1.5x PNCNDA STIMS STI CSAN SANLLOYFITB CSGNJPM BNP PriceBook Tangible/ BAC BARC HSBA KEYGSBBVA LB GLE DBK MSBAC ISPRBS ACA y = 12.32x - 0.09 1.0x BNPC y = 13.39x - 0.05 0.5x DBKBARC HSBAACA UCG R² = 0.81 RBSISP GLE R² = 0.72 0.5x UCG 0.0x 0% 5% 10% 15% 20% 25% 0.0x ROE 2014E 0% 5% 10% 15% 20% 25% ROTCE 2014E

As of September 10, 2013. Source: Thomson One, Company reports, RBC Capital Markets estimates

September 18, 2013 196 Canadian Bank Primer, Sixth Edition

The correlation of bank price to book multiples and expected ROE is very strong, but we would not suggest to investors that, just because a P/B multiple is “on the regression line” based on ROE, a bank is fairly valued relative to peers. Other factors to consider that might make bank stocks that are seemingly fairly valued, relatively attractive, or unattractive are:

 Potential changes in ROE in subsequent years are not captured in a static P/B versus ROE regression;  The regression ignores potential volatility of ROE and earnings quality; and  Quality of management and balance sheet strength are also ignored.

Canadian banks’ P/B valuations (currently ~1.8x) are high by global standards, but so are their ROEs (16–17% expected in 2013–2014) and, unlike some European banks in the bottom left of Exhibit 159, investors do not worry about capital strength. We are often told by global investors that Canadian banks are expensive based on their price-to-book valuations. We believe that valuations reflect high return expectations as opposed to being expensive, and those valuations are likely to be maintained as long as return expectations remain high. Furthermore, the banks’ high ROE allow them to grow book value rapidly and provide high dividend yields, offering investors attractive compound rates of return, even if multiples do not increase.

Our price targets imply P/B multiples of 1.9x, compared to ROE expectations of 16.2% in 2014 and 16.5% in 2015. P/B valuations reached 2.8–2.9x in 2006-2007, when ROEs were 21–22%. We believe that our P/B target multiples are appropriate given current and historical correlations between ROE and P/B and, as is the case for P/Es, the banks’ current and forecast ROEs are being earned under stricter capital and liquidity rules, which in theory would argue for lower risk premiums.

P/B multiples should continue to attract attention in tough cycles, as the balance sheet becomes more tangible than expected earnings. P/B is important to consider when earnings visibility is limited because the great buying opportunities in banks are usually present when earnings and earnings visibility are at their worst, in which case the high P/Es (on trough earnings) would throw off misleading signals (just as low P/Es ahead of earnings downgrades are misleading). Investors need to assess normalized ROE and derive judgment for the appropriate P/B that they want to pay to buy well capitalized banks that have access to liquidity (and therefore should survive downturns) but have a poor earnings outlook.

 P/B troughs have generally risen for the Canadian banks, reflecting the increase seen in trough ROE. ROE at troughs have risen because the banks are less exposed to traditional credit risk than in the past.

Dividend-yield valuation metrics less useful, in our view We find dividend-yield metrics useful if put in the context of expected future growth in dividends, but we do not find this metric as useful as P/E and P/B. Some investors historically looked at Canadian banks on the basis of dividend yield-to-bond yield. We believe that dividend-yield valuations need to be put in context of expected growth in the dividend i.e. whether they are coming from earnings growth (good) or changes in the payout ratio (less good), as well as prospects for interest rates.

 Over time, industries or banks with higher dividend-payout ratios usually trade at higher dividend yields, tending to have lower dividend growth prospects as a result of paying out more of their income as dividends and retaining less to invest in growth.

September 18, 2013 197 Canadian Bank Primer, Sixth Edition

 Lower risk-free rates should make dividends more attractive and push dividend yields down (and stocks up) although extremely low bond yields can reflect market worries about a deflationary environment, which would be an extremely negative environment for financial services companies (Exhibit 160).  Fear of dividend cuts in recessions generally lead to investors somewhat discounting dividend yields as a way to determine valuation floors. The experience in the US and Europe in the 2007-2009 period, when many banks cut their dividends in order to preserve capital, has shown that relying on tempting dividend yields can lead to investment mistakes.  Investors have shown greater comfort in Canadian banks’ commitment to their dividends as the last Canadian bank to cut its dividend was National Bank in the early 1980s and early 1990s. Before that, several banks cut dividends in the 1940s. That greater comfort did not stop dividend yields from going to a median of 7% in early 2009, (and over 10% at Bank of Montreal in February 2009) in which represented 2.5x the 10- year, Canadian, risk-free rate at the time.

Exhibit 160: Dividend yield-to-bond yield relationship declined in usefulness since 2005

Bank Dividend Yield as % of 10 year Bond Yield (Since 1957) 300%

250%

Banks are cheaper relative to bonds 200%

150%

100%

50%

Banks are more expensive relative to bonds 0% 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Banks Dividend Yield as % of Canadian Govt 10-year bond yield

As of August 31, 2013; Canadian Bank Index (prior to 1980 includes banks and trusts). Source: Bank of Canada, RBC Capital Markets Quantitative Research, RBC Capital Markets

When to buy banks (or not) Now that we have highlighted the main methods used to value banks, we examine how we determine when to buy banks (or not). There is no hard and fast rule, but it is generally best to buy banks in times of ROE expansion and positive earnings revisions.

Exhibit 161 shows that, subject to volatility, ROE trends and stock price trends have a positive correlation, as expected. ROE expansion normally occurs during periods of: 1) stronger economic growth, 2) rising equity markets, and 3) active capital markets.

When we assess sector attractiveness, we find that four rules have served us well:

September 18, 2013 198 Canadian Bank Primer, Sixth Edition

 Picking direction is a lot more important than magnitude. Said differently, understanding why banks might go up or down is a more important battle than figuring out by how much.  In good times, stocks go up more than we think they should based on ‘normalized earnings’, and in bad times, they go down more than we think they should based on ‘normalized earnings’.  Valuation metrics are a poor predictor of peaks and troughs. Changes (or expected changes) in the fundamental outlook are more important, in our view.  We do not rely entirely on individual macro metrics because the diversity of the banks’ different businesses makes it dangerous to focus on individual macro drivers of bank stock performance. For example, the correlation between interest rates or GDP with bank share prices is lower than what we perceive investors believe them to be.

Exhibit 161: Bank stocks should perform better when ROE are rising

Bank Index Price Appreciation vs. Change in ROE (Since 1982) Correlation Coefficient*: 0.63 bps 75% 3000

50% 2000

25% 1000

0% 0

-25% -1000

-50% -2000 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Bank Index YoY Appreciation (LHS) ROE YoY Change (RHS) * Correlation since 1997

* Correlation since 1997; As of July 31, 2012; average Big Six Banks; reported, cash ROE includes special items; Source: RBC Capital Markets Quantitative Research, RBC Capital Markets

Bank share prices often, but not always, do well in times of accelerating GDP growth, which is positive for ROE and earnings revisions, and/or declining PCLs. A good predictor of bank share prices during cycle turns is the Canadian leading economic indicator (LEI), which is a composite index of 10 indicators and is the most highly correlated predictor of bank shares (Exhibit 161 and Exhibit 162).57  Periods of strong economic growth stimulate loan demand, because firms feel more confident about their prospects, and banks are more willing to lend them money.

57 A sidebar on the relative appeal of Canadian banks in a weakening economy is important. The weight of Canadian banks in the S&P/TSX Composite Index was ~22% as of June 30, 2013, compared to an 10% weight for US banks in the S&P 500 Composite Index. The remainder of the index is also very different, with the energy and materials sectors aggregating to 38% of the index in Canada and 14% in the US. In an economic slowdown, US investors typically turn to defensive sectors such as healthcare, consumer staples (which includes food, beverage, and tobacco), utilities, and sub-sectors including defense and technology services. The size of those sectors is much smaller in Canada, so Canada-focused investors understandably view bank stocks as defensive in relation to their index (which is 38% energy and materials), which is not the case in the US. Our work shows that in periods of better absolute share price performance (rising equity markets, stronger GDP growth), Canadian banks tend to lag the broad Canadian index, which is heavily weighted to energy and materials sectors, while the opposite happens in periods of weaker absolute share price performance. September 18, 2013 199 Canadian Bank Primer, Sixth Edition

Employment growth or declining unemployment leads to an improvement in loss rates in personal lending, and a stronger consumer often equates to a stronger business sector.  Rising equity markets are also positive: 1) for asset-management businesses because a good component of the assets managed are invested in equities, 2) for retail brokerage businesses because rising equity markets tend to lead to more trading activity by retail clients, and 3) equity underwriting and M&A are likely to be stronger in better equity markets, benefiting the banks’ wholesale businesses. Active capital markets are also very beneficial to wholesale businesses (via trading, equity and debt underwritings, and M&A) as well as retail brokerage businesses, which benefit from higher trading activity and higher fees from distributing share issues. The contribution to revenues of capital markets-related businesses can fluctuate materially, as Exhibit 165 shows.

Exhibit 162: Bank stocks normally correlated with the Canadian LEI

Bank Index Price Appreciation vs. Canadian Leading Economic Indicator Bank Index Price Appreciation vs. Canadian Leading Economic Indicator (Annually since 1977) (Monthly since 1977) Correlation Coefficient: 0.59 Correlation Coefficient: 0.57 6% 80% 100% 10%

4% 60% 75% 8%

3% 40% 50% 5% 2%

1% 20% 25% 3% 0%

-1% 0% 0% 0% -2%

-3% -20% -25% (3%) -4%

-5% -40% -50% (5%) 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 Canadian LEI YoY Change (LHS) Canadian Bank Index YoY change (RHS) Cdn Bank Index YoY Appreciation (LHS) Canadian LEI YoY % change (RHS)

Source: Statistics Canada, RBC Capital Markets Quantitative Research, RBC Capital Markets

Exhibit 163: Bank stocks should perform better in a faster-growing economy or declining loan loss environment

Bank Index Price Appreciation vs. GDP Growth Bank Index Price Appreciation vs. Total PCL (Since 1982) (Since 1982) Correlation Coefficient: -0.17 Correlation Coefficient: 0.16 75% 0.0% 100% 12%

80% 10% 50% 0.4% 60% 8%

25% 0.8% 40% 6%

20% 4%

0% 1.2% 0% 2%

-20% 0% -25% 1.6%

-40% -2%

-50% 2.0% -60% -4% 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Bank Index YoY Appreciation (LHS) Specific PCL as % Loans (RHS Inverted) Bank Index YoY Appreciation (LHS) Real GDP YoY Growth (RHS)

Total provisions for credit loss ratio are total Big Six Banks. Source: Statistics Canada, RBC Capital Markets Quantitative Research, RBC Capital Markets

September 18, 2013 200 Canadian Bank Primer, Sixth Edition

Exhibit 164: Correlation to interest rates depends on rate levels

Bank Index Price Appreciation vs. 10 yr Bond Yield (Since 1982) Correlation Coefficient: -0.22 120% -60%

100% -45%

80% -30%

60% -15%

40% 0%

20% 15%

0% 30%

-20% 45%

-40% 60%

-60% 75% 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Bank Index YoY Appreciation (LHS) Canadian Govt 10 yr Bond Yield YoY Change (RHS Inverted)

Source: Bloomberg, RBC Capital Markets Quantitative Research, RBC Capital Markets

Exhibit 165: Weaker equity and capital markets negatively affect market-sensitive revenues

Market Sensitive Revenue % of Total Revenue* vs. SPTSX Growth (Quarterly since 2000) Correlation Coefficient: 0.44 50%

40%

30%

20%

10%

-10%

-20%

-30% 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13

Market Sensitive Revenue % of Total Revenue SPTSX Index Average QoQ Growth

* Market sensitive revenue includes: underwriting, advisory, brokerage, trading, mutual fund, and investment securities revenues; revenues include special items; data excludes NA Q4/07, CM Q1/08-Q2/08. Source: Company reports, RBC Capital Markets

Picking the right time to buy bank shares is an imperfect science and is actually more art than science, in our view. Fundamental analysis adds a lot of value, in our mind, if looking beyond the near term. Stocks are more likely to reflect their intrinsic value over the long term, because many other factors come into play in the near term.

Leading indicators of profitability can be used for cycle turns but are less useful in normal periods. As economic prospects weakened, securities writedowns rose, and funding costs September 18, 2013 201 Canadian Bank Primer, Sixth Edition

were challenged from mid-summer 2007 to early 2009, we relied on LEI, credit spreads and funding costs as useful tools to determine our cautious view on the banking sector. We also relied on those indicators when we changed our view on the sector to a more positive one in early May 2009 since the direction of those indicators started to turn. We believe that these indicators are best at signalling turns in share prices ahead of turns in earnings, and are particularly useful at cycle peaks and bottoms.

 We did not rely as much on the LEI, credit spreads, and funding costs from mid-2009 until now as positive leading indicators of share prices because their usefulness in normal times is lower. Funding costs are not as good predictors of share prices in ‘normal times’ but were great indicators of share prices from early 2007 to late 2009 when earnings were not a primary driver of valuations. We also monitor these metrics for signs of deterioration outside of normal bands.  LEI that we would look at near cycle peaks and bottoms include the US ISM Manufacturing Composite Index and the ISM Services Index, the US Conference Board LEI, and the Canadian LEI. The historical correlation between Canadian and US LEI is strong. Since the direction of LEI matters more to bank share prices than the level of LEI, a positive turn in LEI is positive for bank shares, in our view. We believe that LEI are crucial to track because they are good advance indicators of employment growth as well as loan losses; therefore, they are important to future bank earnings and share performance. As Exhibit 166 illustrates, bank shares turn well ahead of turns in loan losses as markets normally react to changes in LEI. Improving economic prospects have a nearly immediate effect on bank shares while the effect on profitability (loan losses) lags (Exhibit 167).

Exhibit 166: The Canadian and US LEI are useful for predicting a turn in bank shares in recessionary periods

Bank Index Price Appreciation vs. Canadian Leading Economic Indicator Bank Index Price Appreciation vs. U.S. Leading Economic Indicator (Conf Board) (Monthly since 1977) (Monthly since 1977) Correlation Coefficient: 0.59 Correlation Coefficient: 0.33 100% 10% 100% 20%

75% 8% 75% 15%

50% 5% 50% 10%

25% 3% 25% 5%

0% 0% 0% 0%

-25% (3%) -25% (5%)

-50% (5%) -50% (10%) 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Cdn Bank Index YoY Appreciation (LHS) Canadian LEI YoY % change (RHS) Cdn Bank Index YoY Appreciation (LHS) U.S. Conference Board LEI YoY % change (RHS)

LEI data as of June 2013; all other data as August 2013. Source: RBC Economics, Conference Board Inc., Statistics Canada, RBC Quantitative Research, RBC Capital Markets

September 18, 2013 202 Canadian Bank Primer, Sixth Edition

Exhibit 167: Canadian bank shares normally turn with the LEI, and the LEI leads a peak in loan losses

Bank Index Price Appreciation vs. Canadian Leading Economic Indicator Canadian Leading Economic Indicator vs. Total PCLs as % of Loans (Annually since 1977) (Annually since 1977) Correlation Coefficient: 0.57 6% 80% Correlation Coefficient: -0.11 6.0% -0.5% 5%

4% 60% 4.0% 0.0% 3% 2.0% 40% 2% 0.5% 1% 0.0% 20% 0% -2.0% 1.0% -1% 0% -2% -4.0% 1.5% -3% -20% -6.0% -4%

-5% -40% -8.0% 2.0% 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13

Canadian LEI YoY Change (LHS) Total PCLs as % of Loans (RHS, Inverted) Canadian LEI YoY Change (LHS) Canadian Bank Index YoY change (RHS) As of June 30, 2013, PCLs as of July 31, 2013; * Correlation Coefficient is between Canadian LEI Y/Y change 2-years forward, and Specific PCL rate. Source: Company reports, StatsCan, RBC Capital Markets

 Credit spreads could be a useful indicator for bank shares in uncertain times. The direction of credit spreads is what we think matters, and tightening credit spreads should be positive for bank shares. Credit spreads matter because at their core banks are levered plays on credit but also because credit spreads have an effect on valuations of their securities portfolios. Tightening spreads reduce concerns about potential writedowns. Credit spreads have come in from 2008-2009 peaks for many asset classes (Exhibit 168).

Exhibit 168: Corporate bond spreads are highly inversely correlated to bank stocks during uncertain times

Investment Grade CDS Spreads vs. Canadian Bank Index US Credit Spreads vs. Canadian Bank Index Correlation coefficient: -0.89 Correlation coefficient: -0.84 300 2,500.0 700 2,500.0

250 600 2,000.0 2,000.0 500 200

1,500.0 400 1,500.0 Spread(bps) Spread(bps) 150 1,000.0 300 1,000.0 100 200 500.0 500.0 50 100

- - - - Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13

North American Cdn Bank Index Moody's BAA 10yr Cdn Bank Index

As of August 07, 2013. Source: Bloomberg, RBC Quantitative Research, RBC Capital Markets

 Canadian banks’ funding costs were steady relative to risk-free rates until early 2007, so they had not been useful indicators of share prices, but the correlation with funding costs and banks’ shares during the financial crisis was strong. Since then, funding costs have declined for Canadian banks in both short-term and medium-term markets (and compared to 2008 and to their peers in Europe, both measures have been significantly better recently). We care about bank funding costs because 1) they represent credit markets’ views of banks’ financial strength, and 2) they directionally affect margins, although asset repricing needs to be taken into consideration as well (Exhibit 169).

September 18, 2013 203 Canadian Bank Primer, Sixth Edition

Exhibit 169: Bank share prices and funding costs are highly correlated

Bank Index Price Appreciation vs. 5-yr Funding Spreads Bank Index Price Appreciation vs. 5-yr Funding Spreads (Monthly since 2007) (Since 1999) Correlation Coefficient: -0.76 Correlation Coefficient: -0.59 90% 0.0% 90% 0.0%

75% 0.5% 60% 1.0% 60%

45% 1.0%

30% 30% 2.0% 1.5% 15% 2.0% 0% 0% 3.0%

-15% 2.5%

-30% -30% 4.0% 3.0% -45%

-60% 3.5% -60% 5.0% 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 Jan-07 Jun-07 Nov-07 Apr-08 Sep-08 Feb-09 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12 Nov-12 Apr-13

Bank Index YoY Appreciation (LHS) Canadian Bank 5 yr Senior Debt - Canadian 5 yr Govt Bonds (RHS Inverted) Bank Index YoY Appreciation (LHS) Canadian Bank 5 yr Senior Debt - Canadian 5 yr Govt Bonds (RHS Inverted)

As of August 31, 2013. Source: Bloomberg, RBC Quantitative Research, RBC Capital Markets

The impact of changes in interest rates on bank stocks depends on interest rate levels Declines in US and Canadian Government bond yields were traditionally viewed as positive for bank stocks, which used to make sense but does not at current interest rate levels, in our view. At current interest rate levels, we believe that increases in US and Canadian Government bond yields would be good for bank stocks, to the extent that they reflect expected improvements in the economy and higher risk appetite.

Starting from the higher interest rate levels such as those of the 1980s, declining interest rates were positive as declining interest rates usually accompanied declining inflation, which was positive for banks’ profitability because loan losses should decline and borrowing capacity should increase. Declining interest rates were also good for valuation multiples because the banks’ earnings and dividends became more valuable in relation to risk-free alternatives. Declining interest rates were also generally good for stock markets and debt markets, which was positive for the banks’ wealth management and capital markets businesses.

 In a low interest rate environment, the correlation between interest rates and bank valuations should go from negative (lower rates are good) to positive (lower interest rates are bad) as seen in Exhibit 170. Depressed interested rates usually reflect challenging conditions for banks: economic risk (or at its worse, deflation risk which we highlight in Footnote 53, is a very poor environment for banks to operate under), and a lack of risk appetite. In addition, a sustained low rate environment has a negative effect on bank Net interest margins due to pressured loan and deposit spreads, and the potential for an asset bubble (and subsequent burst) grows.

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Exhibit 170: Correlation between P/E and interest rates turns negative at low rates

Correlation Between Bank Index P/E and Bond Yields (From 1980)

14.5x

12.5x

10.5x

8.5x

R2 = -0.871 Bank IndexBank Forward P/E 6.5x

4.5x

2.5x 1.0% 3.0% 5.0% 7.0% 9.0% 11.0% 13.0% 15.0% 17.0% 19.0% 10-Yr Government of Canada Bond Yield

Source: Bloomberg, RBC Quantitative Research, RBC Capital Markets Research

Banks would benefit from a higher interest rate environment for reasons that are both direct and indirect, assuming that higher interest rates are the result of a stronger economic outlook. Direct positive impacts would include improved net interest income margins and reduced defined benefit liabilities. Indirect impacts would include higher wealth management and capital markets revenues, loan growth and credit quality. Banks are most exposed to short-term to medium-term (i.e. 5 years) interest rates, and an increase in the interest rates they are exposed to, if it materialized, would impact net interest income margins over a multi-year period rather than immediately.

Isolating which bank would benefit the most from the direct impact of higher interest rates (i.e. higher margins) is difficult as banks’ disclosures on exposure to higher interest rates are poor and not necessarily comparable. While it is difficult to determine how much margin upside there might be to a higher interest rate environment, we believe that the banks that would see the largest increase in net income from higher net interest income margins (i.e. ignoring indirect impacts) are those with more exposure to retail banking and weaker efficiency ratios. The two smaller banks (Canadian Western Bank and Laurentian Bank) would benefit more than the larger banks, in our view. In terms of quantifying potential upside, TD Bank estimates that a 25 basis point parallel increase in interest rates would increase annual pre-tax income by approximately $300 million over time, which would contribute a 3.1% increase on net income, using our estimated 2014 net income as a run-rate. Bank of Montreal estimates approximately $190 million, for the same rate scenario, which would contribute a 3.7% increase on net income, using our estimated 2014 net income as a run- rate. The estimates provided by those two banks isolate the direct impact of higher interest rates and might not be comparable, and other banks have not provided estimates.

We would expect higher interest rates to help banks as follows:

 Higher interest rates should lead to an increase in net interest income margins: (1) higher short term rates would likely lead to improved margins fairly rapidly on short term deposits such as high yield savings accounts and GICs, while higher medium term interest rates would gradually (i.e. over a multi-year period) improve margins on zero- September 18, 2013 205 Canadian Bank Primer, Sixth Edition

cost funds; (2) a steeper yield curve would introduce the possibility of establishing carry trades in capital markets businesses and/or through treasury functions; and (3) higher medium term interest rates and borrowers that have greater confidence would likely be conducive to banks being able to charge higher spreads on loans.  Defined benefit pension plan liabilities would decrease. The combination of the impact of higher equity values on invested assets and an increased discount rate on liabilities would have a positive impact on future defined benefit liabilities, which would help book value.  Wealth management and capital markets businesses should do better. Supportive equity markets would improve the profitability of asset management and wealth management businesses through higher asset-based fees, and some segments of capital markets businesses. Also, trading and underwriting activity would likely improve, to the benefit of both retail and institutional brokerage businesses.  We also would expect higher loan growth in a higher interest rate environment on the assumption that nominal GDP growth would also be higher. Loan growth is more highly correlated with economic growth/employment growth than it is with interest rates.

Assessing risk/reward in volatile times In difficult times such as the financial crisis and recession during late 2007 to early 2009, we believe that it is important for investors to understand both the upside potential in owning bank shares, as well as the downside risk. The prior section illustrated our view of share price ‘direction’; this section discusses how to quantify the potential moves.

Normalized P/E and P/B are the best ways to assess upside potential in times of challenged profitability, in our view. The challenge with using P/E—which is our favoured method for valuing banks in normal time periods—in times of rising loan losses is that; 1) if there are no prospects for a positive turn in earnings revisions, markets will likely focus on P/B, and 2) if markets believe that the worst is behind, it might focus on ‘earnings power’ rather than the near-term outlook for earnings.

 Under a scenario where there is no expected share dilution, there are two quick and generally easy ways to determine upside potential for bank shares when the earnings outlook is murky. We would characterize this as the ‘the economic outlook is improving, and banks have enough capital to withstand writedowns and loans losses, so what are they worth on the other side of the valley?’ scenario.  P/B relative to historical averages is the simplest way to determine upside potential, particularly if one looks at price-to-tangible book, because some banks have added significant goodwill and intangibles to their balance sheets, which depresses returns and fair price-to-book multiplies.  One could also look at normalized profitability given current capital positions and then apply a reasonable P/E multiple. A fairly simple way to do this is to make an estimate of balance sheet growth, estimate pre-tax, pre-provision margins, and then apply a normal loan loss estimate rather than the recessionary high loan-loss estimates (the average of the last 20 years might be a starting point) to drive normalized earnings estimates. We used this methodology until early 2010 but then moved to a P/E valuation on our actual forward EPS estimates, because we had greater confidence in our earnings forecasts and believed 2011 and 2012 were closer to normalized profitability.

P/B is the quickest way to quantify downside risk in times of challenged profitability, in our view. We do not believe that P/E is useful in determining valuation-based downside risk for banks when the earnings risk is elevated and prospects for an economic turnaround are September 18, 2013 206 Canadian Bank Primer, Sixth Edition

bleak, similar to the environment in 2008 and early 2009. We believe that P/B methodologies are the best way to determine a potential valuation floor.

 In the early 1990s, banks traded below book value, whereas they troughed at 1.2x in February 2009. We believe that trough multiples should be higher in future cycles because banks are less exposed to credit risk and to business lending than in prior cycles, have more exposure to wealth management, have higher capitalization ratios, and risk- free rates are lower (Exhibit 171 and Exhibit 172).  Looking at price-to-tangible book is a more stringent test of downside risk because it awards little value to goodwill and intangibles, which have grown at some banks (most so at TD Bank).

Exhibit 171: Credit exposure has declined, and P/B troughs have risen

Loan Exposure Canadian Bank Index - P/B vs ROE (Annual since 1989) (Since 1980) Correlation Coefficient: 0.46 19x 3.0x 30%

17x 2.5x 25%

15x 2.0x 20%

13x 1.5x 15%

11x 1.0x 10%

9x 0.5x 5%

7x 89 91 93 95 97 99 01 03 05 07 09 11 13 0.0x 0% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 Total Loans / Common Equity Total Loans / Tangible Book Canadian Bank Index P/B (LHS) Canadian Bank Index ROE (RHS)

Total loans as a multiple of common equity are a total of Big Six Banks; P/B vs. ROE is the Canadian Bank Index. Source: Company reports: RBC Capital Markets Quantitative Research, RBC Capital Markets

Exhibit 172: Risk-Adjusted capital ratios have risen since the late 1980s

Bank Capital Ratios (Annual since 1988)

16%

14%

12%

10%

4% 88 90 92 94 96 98 00 02 04 06 08 10 12 14E

Tangible Common Equity as % of RWA Common Equity % RWA Tier 1 Capital Ratio Tier 1 common / RWA Basel III pro forma common equity Tier 1 ratio

Median of Big Six Banks, Risk-weighted assets is calculated using Basel III starting in Q1/13, Basel II from Q1/08-Q4/12 and Basel I prior to Q1/08. Source: Company reports, RBC Capital Markets

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SECTION 10: Overview of major risks Banks are exposed to a multitude of risks, which is why they must have well rounded risk- management infrastructures, are heavily regulated, and must hold capital and liquidity reserves. The four main sources of risk, in our view are: credit risk, market risk, operational risk, and liquidity and funding risks. Credit risk represents about 81% of banks’ regulatory capital requirements under current rules, operational risk 13%, and market risk 6%. There are currently no global regulatory requirements for liquidity and funding risks, although that will change under the new Basel proposals (see Expected Changes to Regulatory Requirements in Section 8: Capital supports both expected and unexpected risks).

Exhibit 173: Credit RWA contribution is largest

RWA breakdown At Q3/13 ($ millions) BMO BNS CM NA RY TD Total

Credit risk 176,926 236,300 112,200 49,258 233,527 237,928 82.6% 83.7% 83.7% 80.9% 74.2% 83.9% 81.1%

Market risk 10,758 14,500 3,400 3,252 37,933 11,134 5.0% 5.1% 2.5% 5.3% 12.0% 3.9% 6.3%

Operational risk 26,549 31,500 18,400 8,385 43,344 34,459 12.4% 11.2% 13.7% 13.8% 13.8% 12.2% 12.6%

Total RWA 214,233 282,300 134,000 60,895 314,804 283,521

Source: Company reports, RBC Capital Markets

Credit risk is the biggest risk for banks Credit risk is the risk of financial loss due to a borrower or counterparty failing to meet its obligations in accordance with agreed terms. Past credit cycles resulted in severe declines in profitability for Canadian banks, so it is important to take credit risk into consideration when investing in banks.

 Credit risk is traditionally thought of in the context of the banks’ large loan portfolios, but it can also occur in areas such as derivatives (banks would be exposed to counterparty risk), guarantees provided and reinsurance. We discuss credit risk as it pertains to loan books in Section 8: Capital supports both expected and unexpected risks.  Credit risk represents about 80% of banks’ regulatory capital requirements.  Since banks hold fixed-income securities (in trading businesses, corporate treasury books, or investment portfolios), credit risk also arises when bond issuers default and do not pay the principal and interest owed. Counterparty risk as it pertains to trading books and derivative transactions is discussed in Section 5: Wholesale banking is banks’ second- largest division. Banks are more exposed to those risks than they were in the past.  There are many different ways to reduce credit risk, including conservative underwriting practices, active loan sale programs, use of collateral agreements or hedging instruments, or transacting with higher-quality counterparties in higher-quality underlying assets.  Banks will always have credit risk; it is one of the primary reasons why they exist. Successful banks are those that price appropriately for risk and mitigate tail risks, often through diversification of exposures.  Credit risk often hurts banks in areas that they do not expect and are often caught off guard by deterioration in an industry or issuer. Diversification is crucial because banks that fail due to credit-related issues are usually those that are overexposed to weak areas in a credit downturn. September 18, 2013 208 Canadian Bank Primer, Sixth Edition

Requirements for operational risk were introduced in 2008 Operational risk generally relates to potential losses resulting from inadequate or failed processes, employee actions, systems, and/or external events.

 There did not use to be regulatory capital requirements for operational risk, but that changed with the introduction of Basel II in the first quarter of 2008.  Operational risk represents about 13% of banks’ regulatory capital requirements.  Operational risk is extremely difficult to assess properly because: 1) historical costs are hard to measure and 2) allocating capital for low probability and/or frequency but high- effect events is a nearly impossible exercise, in our view. For example, how much capital should have Societe Generale put aside in case one of its futures traders lost billions of dollars on unreported futures trades?  Operating risk is generally viewed as lower for simpler businesses such as retail banking, retail brokerage, and asset management, while more complex businesses such as corporate finance, sales and trading, and payments and settlements are viewed as having higher operational risk.  Supervisors allow banks with sophisticated systems and operational loss history to come up with their own estimates of operational risk capital, with models subject to approvals, under Basel II and Basel III. As of the third quarter of 2013, only CIBC uses this Advanced Internal Ratings-Based approach for operational risk while other Canadian banks use the standardized approach.58

Market risk-weighted assets increased in Q1/12 Market risk comes mostly from capital markets activities, but also from Treasury functions. It refers to the risk that a bank loses money if certain market factors move in an adverse fashion. Market factors include equity markets, interest rates, currencies, credit spreads and commodity prices. Banks that have larger capital markets businesses would generally be more exposed to market risk. Market risk currently represents 7% of banks’ regulatory capital requirements, which increased from about 5% in 2011 as new market risk rules were implemented in the first quarter of 2012.

Unlike with credit risk, it is difficult to assess the magnitude of different banks’ exposures to market risk. Under current rules, we focus on factors such as VaR disclosure, growth in capital markets revenues and reported interest rate sensitivities, but all metrics can lead to erroneous conclusions. For example, we believe that VaR has many flaws, including the following:

58 The standardized approach is based on revenues, with capital charges dependent on the source of revenues. For more details see Section 8; We expect some other large banks to aim for implementation of the Advanced Measurement Approach for operational risk in 2014. September 18, 2013 209 Canadian Bank Primer, Sixth Edition

 VaR benefits from environments in which correlations are low. In times of crisis, correlations rise and market risk becomes higher than VaR would suggest.  No trader intervention is assumed.  VaR only measures the risk on proprietary positions and not the risk of lost revenues in a liquidity-challenged environment.

As outsiders, we are not privy to the stress tests banks perform on their trading positions and securities portfolios which, in our view, are more relevant than VaR. Furthermore, market risk exposures can shift rapidly; for example, a bank may change the position of its balance sheet in a day to take advantage of expected moves in interest rates (which make point-in-time disclosures such as interest-rate gaps and sensitivity to fluctuations in interest rates often outdated by the time the information is published).

Stricter rules and higher capital charges increased market RWA Prior to 2012, market risk had been, in retrospect, underestimated by regulators particularly related to credit risk in trading books, liquidity risk in trading books, and structured finance and off-balance sheet exposures (other areas where risk was underestimated and capital not high enough included reputational risk management and overall liquidity). To improve the market risk framework to be more reflective of bank exposures, the Basel Committee on Banking Supervision (BCBS) published new “Basel 2.5” rules for market risk, which were implemented in the first quarter of 2012. The Committee is continuing to evaluate trading book capital requirements so banks may see additional capital requirements changes in future years.

 The objective of the revised regulatory framework for market risk was to address some of the areas where regulators (and banks) realized risk weightings were too low following the market turmoil of 2007 to mid-2009. For example, banks and regulators came to the conclusion that 1) risk weightings for trading books were too low when the main driving metric (value at risk) was calculated over an environment of low volatility and low correlations between asset classes, 2) credit and liquidity risk in trading books were underestimated, 3) structured-finance holdings were riskier than previously thought, and the holdings of certain tranches in trading books attracted much lower-risk weightings than in banking books.  Relative to the old rules, the rules for trading books are stricter because VaR calculations are more conservative, credit-sensitive positions in trading books attract higher capital charges, and securitization transactions are now treated as if they were held in banking books, thereby attracting more capital than if treated as trading positions.  The committee estimated an increase in market-risk capital requirements of three to four times for international banks, but the impact was lower for most Canadian banks (averaging ~170% increase) because they were not as exposed to securitized assets as many of their global peers and we believe they exited some of the trading book positions and securitization transactions that attracted higher capital charges relative to when the committee provided an estimated effect.  For greater detail please see Section 8: Capital supports both expected and unexpected risks.

Liquidity risk: Concept became reality in 2007-2008 Liquidity risk refers to an institution’s potential inability to access cash in a timely and cost- effective manner to fund obligations. A ‘run’ on a bank can bankrupt it even if the credit quality of its assets is in good shape or capital ratios look healthy (Lehman Brothers, Bear Stearns, and Northern Rock are examples of firms that technically failed because their access to funding dried up—not because they incurred losses on assets that bankrupted them). September 18, 2013 210 Canadian Bank Primer, Sixth Edition

There are currently no global regulatory requirements for liquidity and funding risks, although that will change with the introduction the new Basel III liquidity risk framework (see Expected Changes to Regulatory Requirements in Section 8: Capital supports both expected and unexpected risks for more details). In addition, certain Canadian banks are being required by OSFI to report a Net Cumulative Cash Flow (NCCF) liquidity measure, which will continue to be used domestically while the regulator assesses whether it should be used as an additional metric once the Basel liquidity framework is implemented.

Banks will forever be exposed to liquidity risk as the lending business is generally of longer duration than the duration of deposits, some of which can be ‘called’ by depositors on short notice. There is arguably a social good coming out of banks’ willingness to take on liquidity risk because it creates funding and capital for businesses and individuals to invest in longer-term assets. The recognition of this important social benefit is why governments and central banks will support the provision of emergency liquidity to regulated institutions as well as the creation and maintenance of deposit guarantees. Many of the worst hit institutions in 2007-2008 were unregulated and did not have access to emergency funding or did not benefit from guarantees (structured investment vehicles for example).

Regulators will introduce standards for liquidity, which did not exist on a global basis in the past. Liquidity risk has always been viewed as important by regulators, but we believe that liquidity and funding issues exacerbated the credit and market-related challenges that banks faced in 2007-2009.

 The introduction of requirements for liquidity reflects the 2007-2008 ‘reminders’ to regulators and market participants that theoretically solvent institutions can fail in an environment of reduced or vanished confidence. More cautious liquidity management generally leads to greater holdings of cash, short-term securities, and/or more holdings of government securities, both of which hurt margins in our view. It can also lead to lower risk in that the duration of assets, and liabilities are more closely matched by extending the term of liabilities, which lowers risk but can also reduce margins in a steep yield curve environment.  Key elements of the new requirements include: 1) a liquidity coverage ratio that would ensure that banks have enough liquid assets to survive a period of time with no access to outside funds, 2) a net stable funding ratio that would lead to lower duration mismatches between assets and liabilities primarily by leading to banks extending the term of their liabilities. Banks will have to meet the liquidity coverage ratio standard by 2015, and the BCBS established a lengthy observation period before finalizing a revised net-stable funding ratio (by January 2018), which highlights that the introduction liquidity requirements in an area that is complex and that where requirements did not previously exist is difficult.  Until the new liquidity requirements are implemented, Canada’s regulator is also requiring certain Canadian banks to meet a Net Cumulative Cash Flow (NCCF) survival horizon metric that quantifies the length of time before cumulative net cash flow turns negative, once factoring in the stock of available liquid assets. We believe that the Canadian Regulator will continue to monitor this ratio along with the Basel III LCR and NSFR.  For greater detail please see Expected Changes to Regulatory Requirements in Section 8: Capital supports both expected and unexpected risks.

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Reasons why a bank may run into funding difficulties include:

 Mismanagement of asset-liability duration could leave a bank unable to fund assets if short-term funding becomes unavailable, or it could lead to a rapid squeeze in margins if short-term rates move up but not medium or long-term rates,  Concentration of funding sources, which could leave a bank in trouble if its key funding relationships dry up—even if underlying assets are of good quality,  A balance sheet concentrated in illiquid assets or assets that may suddenly become illiquid,  Over-reliance on short-term source of funds,  Loss of confidence in a bank’s assets, and  Off-balance sheet guarantees becoming on-balance sheet commitments.

Banks least likely to run into funding and liquidity risks are those that:

 Closely match the duration of their assets and liabilities,  Fund their assets with mostly retail deposits, particularly chequing and savings accounts,  Assume conservative haircuts on securities (i.e., how much they could realistically sell assets for if they needed to be rapidly liquidated),  Maintain access to diversified sources of wholesale funding, and  Hold excess cash and liquid securities, which could be liquidated to fund obligations if necessary.

Again, it is difficult to differentiate the relative exposure of the banks to these risks but:

 Personal deposits make up about 40% of total deposits, with TD Bank having the largest percentage (62%) and Scotiabank the smallest (34%). Disclosure on small-business deposits is lacking, but those deposits would also be quite sticky, in our view. We estimate that personal and core business deposits together account for 55–60% of total deposits (Exhibit 174).  We note that Canadian-dollar deposits are insured up to $100,000 by the CDIC59 (a government-owned entity), so those retail deposits are considered sticky. Similarly for retail banks operating in the US, Federal Deposit Insurance Corporation (FDIC) covers up to $250,000 of deposits. 60  Canadian banks generally have diversified sources of funding, and if all else failed, they have access to the Bank of Canada as a lender of last resort.

59 Canadian dollar savings, chequing accounts, and GICs of five years or less are insured by the CDIC up to $100,000. Customers can have up to six accounts insured per institution (one account in their name, one joint account, one trust, one RRSP, one RRIF, and/or an account held for paying realty taxes on mortgage payments). CDIC is a federal corporation. 60 FDIC deposit insurance coverage was raised on July 21, 2010 to $250,000 from $100,000 when President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law. FDIC insurance covers all deposit accounts including checking and savings accounts, money market deposit accounts, and certificates of deposit, and it applies per depositor, per insured depository institution for each account ownership category. September 18, 2013 212 Canadian Bank Primer, Sixth Edition

Exhibit 174: Personal deposits are about 37% of total deposits; estimated retail deposits close to 60%

Personal Deposits as % of Total Deposits 2010 2011 2012 2013 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 BMO 41% 42% 41% 40% 39% 39% 41% 40% 39% 39% 37% 37% 35% 34% 35% BNS 34% 33% 35% 36% 33% 31% 32% 32% 31% 30% 30% 30% 33% 33% 34% CM 50% 49% 47% 46% 46% 43% 47% 49% 48% 48% 46% 39% 39% 39% 39% NA 45% 41% 42% 47% 48% 47% 48% 47% 45% 46% 48% 47% 47% 46% 45% RY 39% 38% 37% 37% 34% 34% 34% 35% 35% 35% 35% 35% 36% 35% 35% TD 58% 58% 57% 58% 61% 62% 60% 60% 59% 59% 59% 60% 61% 61% 62% Median 43% 41% 41% 43% 43% 41% 44% 44% 42% 42% 42% 38% 37% 37% 37% Retail Deposits as % of Total Deposits 2010 2011 2012 2013 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 BMO 59% 58% 58% 58% 57% 57% 58% 59% 59% 58% 58% 57% 56% 55% 56% BNS 53% 52% 52% 54% 50% 48% 47% 46% 45% 46% 47% 48% 51% 51% 52% CM n/a n/a n/a n/a 66% 64% 68% 67% 67% 68% 66% 66% 66% 66% 64% NA 63% 60% 59% 60% 60% 59% 59% 61% 58% 60% 61% 60% 61% 60% 61% RY 64% 64% 63% 62% 54% 54% 57% 58% 58% 58% 59% 58% 59% 58% 58% TD 77% 77% 78% 77% 80% 83% 83% 82% 81% 79% 81% 80% 81% 82% 83%

Median 63% 60% 59% 60% 58% 58% 59% 60% 59% 59% 60% 59% 60% 59% 59%

Source: Company reports, RBC Capital Markets

A bank’s liquidity profile would, in theory, be estimated and compared by adding up cash and other liquid assets, then applying a haircut (discount) on liquid assets to reflect the risk of not being able to liquidate rapidly assets at fair value or not being able to pledge those assets to raise cash. For example, cash and bank deposits would not receive a haircut, while fixed assets would receive a 100% haircut for illiquidity. This process is in line with the BCBS’ calibration of a liquidity coverage standard for banks under Basel III. We believe that 35-40% of banks’ assets are liquid.

 We believe that the banks stress test liquidity and funding positions for bank-specific and systemic-crisis situations, and expect that a majority of core personal deposits would not move between banks in a systemic crisis. Rating agencies consider a bank’s liquidity profile in their assessments of debt and deposit ratings.  While conceptually simple, this historical methodology can also fail if assumptions prove incorrect. For example, the haircuts applied to all asset categories changed drastically from early 2007 to the heart of the global financial crisis (the fall of 2008) (Exhibit 176). Incorrect assumptions can render models useless fairly quickly.  The new Basel III liquidity coverage standard, which comes into effect in 2015, measures a bank’s ability to easily convert highly liquid assets into cash in order to meet cash outflow requirements over a 30 calendar-day period. The BCBS reported results from its global quantitative impact study (QIS), in Sept 2012, that showed the average ratio for large and diversified banks was 93%, and the average for smaller banks was 98%.  In January 2013, The Basel Committee updated its Liquidity Coverage Ratio guidance, which we viewed (and still view) as positive relative to the prior guidance as (1) the definition on liquid assets is more lenient, (2) deposit outflow assumptions are less punitive, and (3) the implementation will be phased in from 2015 to 2019 rather than fully implemented in 2015.

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Exhibit 175: Canadian banks have high liquidity levels

Liquid Assets* % Total Assets (Annual since 2000)

50% 2007 Nov/11 June/13 45% 41.4% 35.5% 36.8% IFRS* IFRS* 40%

35%

30%

25%

20%

15%

10%

0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 11-Nov 2012 01-Jun

Gold, bank notes and other Deposits with regulated FIs Cdn government treasuries/short term Cdn government other securities Secured short-term loans to brokers Other Debt Securities Equities Repos

Liquid assets with no haircuts, and includes gold, bank notes, deposits with Bank of Canada, cheques, deposits with regulated financial institutions, Canadian government treasuries and securities, corporate debt and equity securities, repos and secured call/short-term loans to brokers; All domestic banks; Source: OSFI, RBC Capital Markets

Exhibit 176: Haircuts on secured financings can change rapidly

Typical haircut or initial margin (in percentages) April 2007 August 2008 U.S. Treasuries 0.25 3 Investment grade bonds 0–3 8–12 High-yield bonds 10–15 25–40 Investment grade corporate CDS 1 5 Senior leveraged loans 10–12 15–20 Mezzanine leveraged loans 18–25 35+ ABS CDOs 1 AAA 2–4 95 1 AAA 4–7 95 1 A 8–15 95 1 BBB 10–20 95 1 Equity 50 100 AAA CLO 4 10–20 Prime MBS 2–4 10–20 ABS 3–5 50–60

1 Theoretical haircuts as CDOs were no longer accepted as collateral. Source: IMF, RBC Capital Markets

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SECTION 11: Key differences with US banks This section highlights key differences between the Canadian and US banking systems, including a detailed discussion of the two residential mortgage markets. The section should be of particular interest to investors familiar with US banks but not the Canadian banks. We also highlight how Canada-focused investors have a narrower range of industries to invest in than US-focused investors, which helps Canadian bank shares in downturns. In addition, we highlight relative historical valuations. Banking market is consolidated in Canada The US market remains fragmented, even after years of consolidation, which accelerated between 2008 and 2010, as failing and failed banks, as well as investment dealers were acquired. Larger quasi-national banks have emerged, but only four banks in the US have more than 4% deposit market share with the largest bank having close to 13%. In contrast, there are only eight publicly traded banks in Canada, and the Big Five banks generally have double-digit market share in most banking products with very little room for consolidation. The biggest implication from an investment standpoint is that investors normally do not look at Canadian banks as potential takeover targets, unlike the thousands of small and mid-cap US banks.

 Canadian banks have attempted to merge, but those attempts were thwarted by the government. In 1998, the Minister of Finance turned down merger proposals between Royal Bank and Bank of Montreal, as well as between CIBC and TD. It was also widely reported, but never officially confirmed, that Bank of Montreal and Scotiabank had a merger proposal denied by the government in 2002. No formal political position for or against bank mergers has been established since. Politically, it may be difficult to support mergers or foreign takeovers because polls have consistently shown that Canadians are not in support of bank mergers.

Canadian banks are more diversified Canadian banks are very diversified by product, business line, client type, and geography. Business lines are reported differently, but they are broadly broken down as follows:

 Retail banking operations comprise branch banking and online banking, with products including mortgages, credit cards, term loans, car loans, unsecured and secured lines of credit including home equity lines of credit (HELOCs), transaction accounts, savings accounts, and term deposits. Small business and commercial banking are generally considered to be part of retail banking. Some banks also have insurance operations and provide creditor, travel, home and auto, and life insurance (which are sometimes included in the wealth management division). Retail banking makes up 50–70% of income in normal periods.  Wholesale banking deals with corporate and institutional clients. Activities include corporate lending, trading businesses, underwriting, and advisory (i.e., M&A). Wholesale businesses account for 10–40% of income in normal periods, depending on the bank.  Wealth management includes retail brokerage (full-service and discount), mutual fund management, trust, and private counselling, as well as, for some banks, fixed-term deposits. Those businesses make up 10–20% of banks’ income in normal periods.

Most banks in the US market have not historically been as diversified by product line. Specialist firms historically dominated the investment banking, wealth management, credit card, and mortgage landscapes, but the environment has changed in the last few years with many of these firms being acquired by larger banks. Even after the consolidation of many September 18, 2013 215 Canadian Bank Primer, Sixth Edition

specialist firms into banks, however, there are still only a few banks that are as diversified as the Canadian banks (the money centres and a few large-cap banks). Regional banks in general are much less diversified.

Most publicly traded US banks are pure domestic banks. Those with investment-banking businesses have non-US businesses, but outside of that most US banks are exactly that: US banks. Canadian banks, on the other hand, have expanded beyond their home base, and we expect them to continue doing so via acquisitions.

Canadian banks’ non-domestic earnings have contributed about 20–50% to earnings for many years, and most have been active on the acquisition front in recent years (Exhibit 177 and Exhibit 43). We expect acquisitions to continue outside Canada given that the Canadian financials market is largely consolidated, leaving few opportunities for banks to make meaningful acquisitions. Also, Canadian retail-loan growth is unlikely to be fuelled by an increase in leverage as it was for most of the 2000s, and as such, slower retail-loan growth should be expected in Canada.

 TD Bank has the largest retail presence in the US after investing $21 billion in acquisitions since 2005. More than half of its branch count is in the US, and over one- quarter of its earnings are from the US. The most recent US deals included the acquisition of Chrysler Financial in 2011 and two acquisitions in Florida in 2010: the FDIC-assisted acquisition of Riverside National Bank, and the non-FDIC assisted acquisition of The South Financial Group (allocated goodwill for these acquisitions total approximately $0.6 billion).  Scotiabank is Canada’s most international bank, with more than half of its 80,000 employees and 3,100 branches located outside Canada. In recent years, about 40% of core earnings came from outside Canada. Scotiabank has been an active consolidator of banks in Latin America and in Asia in recent years, with international acquisitions totalling about $6 billion since 2000—most recently the January 2012 acquisition of Banco Colpatria in Colombia for $1 billion.  Royal Bank closed the sale of its US retail banking operations to the PNC Financial Services Group in March 2012 for approximately US$3.6 billion. The bank had invested about $7 billion in US retail banking acquisitions since 2000. In the past decade, the bank spent about $4 billion for US wealth management, custody, capital markets, and insurance acquisitions. In July 2012, Royal Bank acquired the 50% stake of the RBC Dexia joint venture that it did not already own from its partner Banque Internationale à Luxembourg (formerly Dexia Banque Internationale à Luxembourg) for C$1 billion. RBC also purchased Blue Bay Asset Management in the UK for $1.6 billion in 2010, and expanded its presence in Caribbean banking with a $2.2 billion acquisition in 2008. In recent years, the capital markets and wealth management divisions have hired teams of people or opened offices in the US, Asia, and Europe.  Bank of Montreal closed its acquisition of Marshall & Ilsley (M&I) in July 2011 for US$4.1 billion, the largest acquisition by market cap in the bank’s history. Prior to that, the bank invested approximately $2 billion in the US around its Chicago-land and Milwaukee footprint with a number of small retail banking acquisitions since 2000. In December 2009, the bank also purchased the North American franchise of the Diners Club credit card for $840 million. Bank of Montreal generally earns about 15–20% of its earnings from outside Canada, and 20% of its employees are located non-domestically.  CIBC has a long-standing presence in the Caribbean (since 1920), which was expanded with the $2.2 billion acquisition of FirstCaribbean in 2007 and the March 2010 acquisition of a 22% stake in the Bank of N.T. Butterfield & Son Limited in the Caribbean for $150 million. In 2011, CIBC also acquired of a 41% stake in American Century

September 18, 2013 216 Canadian Bank Primer, Sixth Edition

Investments, a US asset manager for US$848 million. The bank generates up to 15% of its earnings from non-domestic sources.  National Bank has the smallest international exposure, with about 5% of earnings coming from outside Canada.

Exhibit 177: Approximately 20–50% of earnings are generated outside Canada

Banks: Non-Canadian Exposure

47% 46% 37% 34%34% 34% 30%

20% 17% 13% 4% 1%

BNS BMO TD RY CM NA

% of 2012 Revenue % of 2012 Net Income

Source: Company reports, RBC Capital Markets

Canadian banks’ assets: Less risk but lower margins Canadian banks appear highly levered compared to US banks, and margins appear very thin, which we believe is misleading.

Canadian banks’ net interest income margins are 1.8% compared to the 3.4% we consider their US bank peers61 to be, while the Canadian banks equity-to-assets ratio is 5.3% compared to 9.8% for their US bank peers.

 Importantly, however, risk-weighted assets represent 30% of balance sheet assets for Canadian banks, compared to 60% for US banks. We believe that this is a function of Canadian banks having more mortgages as well as lower-risk securities on their books. We therefore think it is more meaningful to compare profitability and capital ratios on a risk-weighted basis.  Net interest income as a percentage of risk-weighted assets was 4.9% at Canadian banks compared to 3.7% for US banks in the last 12 months.

Equity to risk-weighted assets is about 13% for Canadian banks and close to 15% for their US bank peers. The median Basel III common equity Tier 1 ratio of 9.1% in Canada is lower than the 9.2% median for US banks, although the ratio is not entirely comparable as the Canadian banks implemented Basel III in Q1/13, where as the US banks have yet to fully adopt Basel III capital requirements.

61 US bank peer group includes BAC, C, JPM, BBT, FITB, KEY, MTB, PNC, STI, USB, and WFC. September 18, 2013 217 Canadian Bank Primer, Sixth Edition

Canadian banks’ ROE has been materially higher than US banks’ ROE in recent years because they benefited from their expansion into wealth management, they were not as affected by the capital markets dislocation and credit losses in the US during 2007–2009, and they have suffered less pressure on their fees. Furthermore, larger US banks had generally been more acquisitive than Canadian banks, to the detriment of their ROE. In Canada, ROE had been in the 21–23% range from mid-2006 to late 2007, then declined to a median of 13% in 2009, and then recovered 17-18%. In the US, ROE had been in the 15–17% range from mid-2006 to late 2007, was negative for much of 2008 and 2009, and is now about 12% (Exhibit 178).

Exhibit 178: ROE has been higher in Canada than in US

ROE (unadjusted)

25%

20%

15%

10%

-5%

-10%

-15% Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11

Spread (Can - U.S.) U.S. banks Canadian banks

Source: RBC Capital Markets Quantitative Research, RBC Capital Markets

September 18, 2013 218 Canadian Bank Primer, Sixth Edition

Exhibit 179: Balance sheet ratios – Canadian and US banks

Cdn Banks vs. U.S. Banks 2010 2011 2012 2013 (Since 2010) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Bank of Montreal 4.6% 4.6% 4.7% 4.7% 4.0% 4.1% 4.9% 4.5% 4.5% 4.6% 4.6% 4.8% 4.8% 4.9% 5.0% Scotiabank 4.3 4.3 4.2 4.5 4.0 4.3 4.3 4.3 4.4 4.7 4.8 5.2 5.0 5.0 5.1 CIBC 3.4 3.5 3.5 3.6 3.1 3.1 3.2 3.3 3.5 3.6 3.7 3.8 3.8 3.9 4.0 Avg. common equity National Bank of Canada 4.0 3.9 3.8 4.2 3.6 3.4 3.5 3.5 3.5 3.6 3.7 3.6 3.7 3.8 3.9 Avg. Total Assets Royal Bank of Canada 5.0 5.1 4.9 4.7 4.1 4.2 4.4 4.2 4.5 4.6 4.7 4.8 4.8 4.8 4.9 TD Bank Financial Group 6.3 6.1 6.3 6.3 5.2 5.1 5.2 5.2 5.2 5.2 5.4 5.5 5.4 5.5 5.4 Canadian Big Six Median 4.5% 4.4% 4.5% 4.6% 4.0% 4.2% 4.3% 4.3% 4.5% 4.6% 4.7% 4.8% 4.8% 4.9% 4.9% U.S. Peer Average 8.1% 8.4% 8.8% 8.9% 9.0% 9.1% 9.0% 9.2% 9.4% 9.5% 9.7% 9.7% 9.8% 9.8% n/a Bank of Montreal 12.5% 13.3% 13.5% 13.5% 13.0% 13.8% 11.5% 12.0% 11.7% 12.0% 12.4% 12.6% 11.1% 11.3% 11.2% Scotiabank 11.2 11.2 11.7 11.8 11.8 12.0 12.3 12.2 11.4 12.2 12.6 13.6 10.3 10.7 11.0 CIBC 13.0 13.7 14.2 13.9 14.3 14.7 14.6 14.7 14.3 14.1 14.1 13.8 13.2 13.6 13.0 National Bank of Canada 12.5 12.7 13.0 14.0 14.6 14.1 13.9 13.6 12.7 13.0 12.7 12.0 10.8 11.2 11.4 Tier 1 ratio* Royal Bank of Canada 12.7 13.4 12.9 13.0 13.2 13.6 13.2 13.3 12.2 13.2 13.0 13.1 12.9 12.6 12.8 TD Bank Financial Group 11.5 12.0 12.5 12.2 12.7 12.7 12.9 13.0 11.6 12.0 12.2 12.6 10.9 10.8 11.0 Canadian Big Six Median 12.5% 13.0% 13.0% 13.2% 13.1% 13.7% 13.0% 13.2% 11.9% 12.6% 12.7% 12.9% 11.0% 11.2% 11.3% U.S. Peer Average 11.2% 11.6% 12.0% 12.2% 11.9% 11.9% 12.0% 12.3% 12.0% 11.6% 11.6% 11.7% 11.5% 11.6% n/a Bank of Montreal 0.82% 0.61% 0.51% 0.60% 0.70% 0.59% 0.43% 0.62% 0.24% 0.33% 0.39% 0.31% 0.28% 0.23% 0.12% Scotiabank 0.55 0.49 0.39 0.36 0.37 0.35 0.32 0.35 0.32 0.31 0.47 0.36 0.33 0.35 0.31 CIBC 0.83 0.71 0.49 0.33 0.55 0.42 0.53 0.51 0.56 0.51 0.52 0.54 0.43 0.43 0.52 Loan loss provision National Bank of Canada 0.32 0.26 0.20 0.26 0.35 0.29 0.16 0.27 0.24 0.25 0.20 0.22 0.15 0.25 0.22 Loans (average) Royal Bank of Canada 0.53 0.51 0.41 0.41 0.34 0.32 0.37 0.32 0.30 0.39 0.35 0.38 0.37 0.29 0.27 TD Bank Financial Group 0.81 0.57 0.53 0.61 0.51 0.33 0.42 0.38 0.45 0.39 0.44 0.55 0.37 0.39 0.44 Canadian Big Six Median 0.68% 0.54% 0.45% 0.39% 0.44% 0.34% 0.40% 0.37% 0.31% 0.36% 0.41% 0.37% 0.35% 0.32% 0.29% U.S. Peer Average 2.85% 2.20% 1.94% 1.47% 1.07% 0.98% 0.94% 0.84% 0.78% 0.69% 0.83% 0.77% 0.61% 0.37% n/a Bank of Montreal 62% 64% 67% 65% 72% 77% 80% 73% 73% 70% 68% 64% 65% 68% 71% Scotiabank 71 81 79 63 78 80 82 82 87 82 84 86 88 91 89 CIBC 106 105 100 97 101 103 101 97 96 98 99 103 108 111 112 Reserve National Bank of Canada 144 148 173 172 166 169 162 149 154 165 157 149 157 164 151 Gross impaired loans Royal Bank of Canada 87 83 82 79 73 75 90 88 89 89 96 93 96 94 97 TD Bank Financial Group 104 104 105 101 102 106 106 104 102 110 114 113 116 116 115 Canadian Big Six Median 96% 93% 91% 88% 89% 91% 95% 92% 92% 94% 97% 98% 102% 103% 105% U.S. Peer Average 86% 88% 88% 88% 85% 83% 81% 78% 77% 76% 75% 75% 73% 73% n/a Bank of Montreal 1.91% 1.80% 1.66% 1.69% 1.37% 1.23% 1.00% 1.15% 1.12% 1.19% 1.17% 1.20% 1.15% 1.11% 1.00% Scotiabank 1.52 1.91 1.91 1.54 1.18 1.14 1.09 1.04 0.99 1.02 1.01 1.01 0.93 0.91 0.92 CIBC 1.10 1.10 1.14 1.03 0.83 0.78 0.78 0.80 0.81 0.79 0.80 0.76 0.72 0.69 0.66 Gross impaired loans National Bank of Canada 0.83 0.80 0.67 0.65 0.61 0.57 0.53 0.55 0.51 0.47 0.46 0.46 0.42 0.40 0.43 EOP Loans Royal Bank of Canada 0.99 1.02 0.97 0.97 1.15 1.06 0.68 0.67 0.65 0.65 0.57 0.59 0.56 0.55 0.51 TD Bank Financial Group 0.90 0.87 0.84 0.83 0.74 0.69 0.66 0.66 0.64 0.60 0.58 0.61 0.60 0.59 0.61 Canadian Big Six Median 1.04% 1.06% 1.05% 1.00% 0.99% 0.92% 0.73% 0.73% 0.73% 0.72% 0.69% 0.69% 0.66% 0.64% 0.64% U.S. Peer Average 4.63% 4.53% 4.40% 4.19% 4.15% 3.96% 3.84% 3.67% 3.55% 3.37% 3.29% 3.15% 3.08% 2.79% n/a Bank of Montreal 1.18% 1.14% 1.11% 1.09% 0.99% 0.95% 0.80% 0.84% 0.81% 0.83% 0.79% 0.77% 0.75% 0.76% 0.71% Scotiabank 1.09 1.55 1.50 0.97 0.92 0.91 0.90 0.86 0.85 0.83 0.85 0.86 0.81 0.83 0.82 CIBC 1.16 1.16 1.13 1.00 0.83 0.80 0.79 0.77 0.78 0.78 0.79 0.78 0.77 0.77 0.74 Reserve National Bank of Canada 1.19 1.18 1.16 1.11 1.01 0.96 0.86 0.82 0.78 0.77 0.72 0.69 0.66 0.66 0.65 EOP Loans Royal Bank of Canada 0.86 0.85 0.80 0.77 0.84 0.80 0.61 0.59 0.58 0.58 0.54 0.55 0.53 0.52 0.50 TD Bank Financial Group 0.94 0.90 0.88 0.84 0.76 0.73 0.70 0.68 0.65 0.65 0.67 0.69 0.69 0.68 0.70 Canadian Big Six Median 1.13% 1.15% 1.12% 0.98% 0.88% 0.86% 0.79% 0.80% 0.78% 0.78% 0.75% 0.73% 0.72% 0.72% 0.71% U.S. Peer Average 3.81% 3.75% 3.61% 3.40% 3.25% 3.05% 2.88% 2.68% 2.56% 2.42% 2.28% 2.19% 2.12% 1.90% n/a

Note: US banks include C, BAC, JPM, BBT, FITB, KEY, MTB, PNC, STI, USB, and WFC. Source: Company reports, SNL Datasource, RBC Capital Markets

September 18, 2013 219 Canadian Bank Primer, Sixth Edition

Exhibit 180: Profitability ratios – Canadian and US banks

Profitability vs. U.S. Peer Group 2010 2011 2012 2013 (Since 2010) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Bank of Montreal 0.64% 0.73% 0.66% 0.71% 0.72% 0.65% 0.68% 0.62% 0.71% 0.70% 0.72% 0.80% 0.74% 0.69% 0.79% Scotiabank 0.78% 0.85% 0.80% 0.82% 0.86% 0.87% 0.83% 0.74% 0.82% 0.83% 0.79% 0.85% 0.87% 0.80% 0.84% CIBC 0.76% 0.67% 0.82% 0.75% 0.86% 0.72% 0.76% 0.73% 0.82% 0.83% 0.85% 0.83% 0.88% 0.86% 0.92% National Bank of Canada 0.76% 0.69% 0.69% 0.73% 0.80% 0.72% 0.74% 0.66% 0.76% 0.73% 0.72% 0.70% 0.73% 0.74% 0.78% ROA Royal Bank of Canada 0.93% 0.85% 0.86% 0.74% 0.99% 0.83% 0.84% 0.77% 0.90% 0.84% 0.94% 0.90% 0.97% 0.88% 1.05% TD Bank Financial Group 0.98% 0.86% 0.85% 0.79% 0.96% 0.87% 0.90% 0.87% 0.89% 0.86% 0.88% 0.83% 0.90% 0.85% 0.73% Canadian Big Six Median 0.77% 0.79% 0.81% 0.75% 0.86% 0.78% 0.80% 0.73% 0.82% 0.83% 0.82% 0.83% 0.88% 0.83% 0.82% U.S. Peer Average 0.51% 0.63% 0.73% 0.86% 0.93% 0.88% 1.04% 0.79% 0.98% 1.01% 1.17% 1.02% 1.06% 1.28% n/a Bank of Montreal 14.5% 16.2% 14.0% 15.5% 18.1% 17.4% 13.7% 13.3% 17.7% 16.3% 15.0% 16.1% 15.4% 14.2% 16.1% Scotiabank 18.4% 20.2% 19.0% 18.8% 21.2% 25.3% 19.5% 16.7% 20.1% 18.6% 24.9% 16.6% 16.9% 16.0% 17.3% CIBC 21.9% 21.9% 20.2% 15.0% 24.9% 24.6% 17.4% 23.0% 22.7% 21.9% 22.1% 21.9% 20.2% 21.9% 21.8% National Bank of Canada 14.4% 17.5% 17.9% 18.2% 22.4% 20.6% 21.6% 18.4% 22.1% 34.5% 21.8% 19.9% 20.2% 23.7% 22.0% ROE Royal Bank of Canada 18.9% 16.9% 16.1% 15.7% 25.0% 20.4% 19.7% 18.0% 20.4% 16.5% 23.1% 19.0% 20.1% 18.3% 21.3% TD Bank Financial Group 15.4% 14.1% 13.6% 10.9% 18.4% 16.9% 17.3% 16.9% 14.6% 16.5% 15.9% 14.6% 15.9% 14.9% 13.1% Canadian Big Six Median 16.9% 17.2% 17.0% 15.6% 21.8% 20.5% 18.5% 17.5% 20.3% 17.5% 21.9% 17.8% 18.5% 17.2% 19.3% U.S. Peer Average 5.5% 7.2% 6.6% 7.8% 8.6% 8.0% 9.6% 7.3% 9.0% 9.2% 10.2% 8.9% 9.2% 11.0% n/a Bank of Montreal 1.5% 1.8% 1.6% 1.8% 1.9% 1.9% 1.4% 1.4% 2.1% 1.9% 1.8% 2.1% 2.0% 1.8% 2.1% Scotiabank 1.8% 2.0% 2.0% 2.0% 2.2% 2.8% 2.2% 1.9% 2.2% 2.1% 3.1% 2.2% 2.3% 2.1% 2.4% CIBC 2.2% 2.3% 2.2% 1.7% 2.7% 2.7% 2.0% 2.6% 2.8% 2.7% 2.9% 2.9% 2.6% 2.7% 2.7% National Bank of Canada 1.4% 1.9% 2.0% 2.1% 2.5% 2.4% 2.5% 2.1% 2.5% 3.9% 2.6% 2.3% 2.3% 2.7% 2.6% RoRWA Royal Bank of Canada 2.4% 2.2% 2.1% 2.1% 3.0% 2.6% 2.5% 2.3% 2.6% 2.2% 3.2% 2.6% 2.8% 2.4% 2.9% TD Bank Financial Group 2.9% 2.6% 2.6% 2.2% 3.2% 2.9% 3.0% 3.0% 2.5% 2.8% 2.8% 2.6% 2.7% 2.5% 2.2% Canadian Big Six Median 2.0% 2.1% 2.0% 2.0% 2.6% 2.6% 2.4% 2.2% 2.5% 2.5% 2.8% 2.4% 2.4% 2.4% 2.5% U.S. Peer Average 0.9% 1.1% 0.3% 0.7% 1.2% 0.5% 1.5% 0.9% 1.2% 1.3% 1.1% 1.1% 1.4% 1.6% n/a Bank of Montreal 49.5% 50.2% 46.1% 50.2% 50.5% 49.2% 45.7% 40.8% 43.7% 46.5% 42.6% 48.6% 45.7% 46.8% 47.0% Scotiabank 45.0% 46.9% 42.6% 43.1% 45.7% 54.0% 46.6% 44.9% 48.6% 47.3% 53.4% 47.0% 46.5% 46.7% 46.9% CIBC 50.5% 48.8% 45.7% 49.4% 42.8% 42.6% 43.0% 44.4% 41.7% 43.2% 40.2% 36.2% 41.7% 41.9% 42.3% Fee revenue National Bank of Canada 53.2% 55.4% 49.9% 52.4% 44.9% 50.7% 49.2% 48.3% 50.8% 60.0% 50.6% 54.3% 49.8% 52.7% 48.6% Total revenue Royal Bank of Canada 61.4% 60.4% 57.9% 61.5% 61.3% 60.2% 58.1% 55.8% 60.4% 56.2% 57.6% 57.8% 58.5% 58.5% 53.0% TD Bank Financial Group 43.4% 41.5% 38.4% 40.5% 38.5% 36.8% 34.7% 37.6% 34.7% 36.0% 34.7% 34.8% 35.6% 35.0% 30.3% Canadian Big Six Median 50.0% 49.5% 45.9% 49.8% 45.3% 49.9% 46.1% 44.6% 46.2% 46.9% 46.6% 47.8% 46.1% 46.7% 47.0% U.S. Peer Average 44.8% 43.6% 44.2% 43.3% 43.1% 41.7% 44.3% 41.6% 44.4% 43.6% 45.3% 44.4% 45.2% 47.2% n/a Bank of Montreal 52.9% 53.7% 54.4% 55.4% 52.0% 54.1% 52.8% 54.2% 55.4% 54.9% 54.6% 55.3% 54.5% 55.2% 54.7% Scotiabank 47.5% 46.2% 48.3% 49.2% 48.0% 53.7% 51.6% 52.7% 49.6% 50.8% 49.0% 51.2% 49.1% 49.8% 49.6% CIBC 49.5% 52.3% 49.3% 51.9% 50.1% 51.5% 49.8% 49.3% 49.1% 49.8% 49.6% 50.6% 49.4% 49.5% 48.9% Efficiency National Bank of Canada 57.9% 57.9% 56.9% 58.8% 56.5% 57.2% 56.6% 58.6% 55.9% 56.6% 54.6% 59.5% 55.3% 56.0% 53.9% Ratio Royal Bank of Canada 45.7% 47.6% 47.3% 48.7% 44.1% 45.3% 46.3% 45.7% 44.9% 45.3% 43.0% 44.9% 43.7% 45.0% 44.5% TD Bank Financial Group 47.0% 47.1% 46.2% 49.9% 45.0% 46.8% 45.6% 48.5% 45.1% 47.1% 46.1% 48.9% 45.0% 47.5% 45.4% Canadian Big Six Median 48.5% 49.9% 48.8% 50.9% 49.0% 52.6% 50.7% 51.0% 49.3% 50.3% 49.3% 50.9% 49.3% 49.6% 49.2% U.S. Peer Average 56.1% 57.0% 57.8% 63.0% 61.4% 71.7% 61.0% 68.5% 64.8% 63.3% 64.2% 63.7% 61.6% 60.9% n/a Bank of Montreal 1.9% 1.8% 1.9% 1.9% 1.8% 1.8% 1.8% 2.0% 2.1% 1.9% 1.9% 1.8% 1.9% 1.7% 1.8% Scotiabank 1.9% 1.8% 1.8% 1.9% 1.8% 1.7% 1.7% 1.7% 1.7% 1.8% 1.7% 1.7% 1.7% 1.6% 1.7% CIBC 2.1% 2.1% 2.0% 2.2% 2.1% 2.0% 2.0% 2.1% 2.2% 2.1% 2.2% 2.3% 2.1% 2.1% 2.1% Net Interest National Bank of Canada 1.8% 1.6% 1.8% 1.8% 1.9% 1.6% 1.7% 1.7% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% Margin Royal Bank of Canada 2.1% 2.0% 2.0% 1.9% 1.8% 1.7% 1.9% 1.9% 1.9% 1.9% 2.0% 1.9% 1.9% 1.8% 1.9% TD Bank Financial Group 2.4% 2.3% 2.3% 2.3% 2.4% 2.2% 2.4% 2.3% 2.2% 2.2% 2.2% 2.2% 2.2% 2.2% 2.3% Canadian Big Six Median 2.0% 1.9% 1.9% 1.9% 1.9% 1.8% 1.8% 2.0% 2.0% 1.9% 2.0% 1.9% 1.9% 1.8% 1.8% U.S. Peer Average 3.4% 3.6% 3.6% 3.6% 3.5% 3.4% 3.4% 3.4% 3.4% 3.3% 3.3% 3.3% 3.2% 3.2% n/a

US peer group includes BAC, C, JPM, BBT, FITB, KEY, MTB, PNC, STI, USB, WB, and WFC; US banks are as of calendar quarters, Canadian banks are as of fiscal quarters. Source: Company reports, SNL Data Source, RBC Capital Markets

Canadian banks have traded at higher valuations Canadian banks trade at higher P/B multiples than US banks given higher profitability. The banks have earned higher ROE than US banks since the early 2000s, initially because they grew low-capital fee businesses such as wealth management and capital markets businesses, then by incurring lower writedowns and loan losses, and less pressure on fees. Canadian banks have also been less active consolidators than some of their more active US peers, which has helped relative ROE comparisons. The higher ROE have translated into higher P/B valuations for Canadian banks (Exhibit 181).

September 18, 2013 220 Canadian Bank Primer, Sixth Edition

Exhibit 181: P/B multiples for Canadian bank stocks higher than US banks recently

P/B - Canadian Bank Index relative to US Bank Index P/B (Since 1980) Correlation Coefficient: 0.24 600%

500%

400%

Canadian Banks are more expensive relative to US Banks 300%

200%

100%

Banks are less expensive relative to US Banks 0% 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

Canadian Bank Index P/B as % of US Bank Index P/B Canadian Bank Index ROE as % of US Bank Index ROE

Canadian banks are based on eight publicly traded banks, and US banks are based on the S&P Banking Index. Source: RBC Capital Markets Quantitative Research

2008-2010 was a different experience for Canadian banks The 2008–2010 period was a different experience in Canada from the experience of US banks and economy:

 Job losses in the Canadian economy were fewer than in the US economy, and the recovery came earlier in Canada. Using the unemployment rate to support this point, we note that the Canadian unemployment rate was 5.9% at its trough in February 2008, rose 280 basis points to the peak of 8.7% in August 2009, and has since come down to 7.1%. Conversely, the US unemployment rate was 4.4% at its trough in May 2007, rose 570 basis points to the peak of 10.1% in October 2009, and has since come down to 7.3%. (Exhibit 32)  The Canadian housing market held up much better than the US market. Prices dipped in late 2008 to early 2009 but have recovered since, unlike in the US. Canadian housing prices are still near peak levels whereas US housing prices are down approximately 10% from peak levels (Exhibit 50). We discuss the Canadian mortgage and housing market in greater detail in the following pages.  Credit losses rose, but losses as a percentage of loans were lower than in the recessions of the early 1980s, 1990s, and 2000s. This is in contrast to the US banking system’s experience. (Exhibit 33)  Writedowns were lower than they were for many global banks with exposure to capital markets.  Reported ROE troughed at just 13% in 2009 compared to negative ROE for US banks. (Exhibit 33)  Government involvement in the Canadian banking system was minimal compared to the US. The Canadian Government helped the banks from a funding perspective during the banking crisis, but there were no capital injections, bailouts, or failures, unlike in the US.  Some but not all Canadian banks raised common equity during the crisis.

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 Dividends were maintained at all Canadian banks, whereas they were cut almost across the board in the US.  Loan growth remained positive for Canadian banks, whereas it turned negative for US banks. (Exhibit 33)  US banks’ revenues have been pressured by government reviews of credit cards businesses, overdraft fees, and interchange fees. Except for slight changes to credit cards businesses62 , Canadian banks have not faced similar pressure on fees.  As a result of the many differences highlighted above, we expect all but one of the Canadian banks to have higher 2014 earnings per share than at their 2006–2007 peaks. Based on consensus estimates, there are only a few US banks in that category (Exhibit 34), and we note that the banks shown in our table are only the ones that have survived the crisis and recession.

Canadian banks account for a greater weight of the index The Big Six banks are important components of the S&P/TSX Composite Index, accounting for 22% of the weight of the index and about two-thirds (66%) of the weight of the S&P/TSX Financials Index as of July 31, 2013. The banks’ weight in the index is at peak levels and up from its low of 15% in late 2008 (Exhibit 14). In contrast, US banks make up 10% of the S&P500 Index, down from a peak of 13% in 2006.

 The contrast is also striking when looking at the 20 largest stocks in the respective indices. The three largest companies in Canada are banks, and the smallest of the Big Five Banks is the 13th-largest company in Canada (Exhibit 15). In the US, Wells Fargo is the largest bank, as measured by market capitalization, and it is the 14th-largest company in the S&P 500 Index. There are only three banks in total amongst the top 20, with JP Morgan ranked 16th and Citigroup ranked 20th.(Exhibit 15)  The other key difference is that the makeup of the remainder of the index is much more weighted toward energy/mining in the Canadian index than it is in the US index. Other key sectors in the main Canadian composite index are Energy (25%) and Materials (14%). No other sector makes up more than 6% of the composite index. Again, looking at the top 20 stocks in the Canadian index, it is clear that investors have few very large companies to invest in outside banks, energy, and materials. The makeup of the top 20 stocks in the US index also highlights the broader diversification of the US index.  The differences highlighted above lead to important differences in institutional investor perspectives. In Canada, banks are viewed as a sector that must be owned, whereas, in the US, it is more feasible to ignore the sector given its lower importance in the index. Also, because the energy and materials sectors are very cyclical, investors perceive Canadian banks as, relative to the rest of the index, defensive stocks. This is in contrast with the US, where banks are generally perceived as cyclical stocks that should lag in a lagging economy.

Mortgage markets are very different There are many material differences between the Canadian and US mortgage markets, in terms of innovation, credit risk, interest risk, and regulatory capital requirements.

62 New credit card rules in Canada came into effect on September 1, 2010, which had a modest negative effect on banks, in our view, but not big enough to be separately disclosed. The rules change included: 1) the allocation of payments on balances having different interest rates (which is now be more beneficial for customers than before); 2) a minimum 21-day grace period on making payments after the end of the billing cycle; and 3) a 21-day interest- free period for customers who pay their balance in full (which is in contrast to the general practice of charging interest on all new purchases if a balance was carried in the prior month). September 18, 2013 222 Canadian Bank Primer, Sixth Edition

Credit risk is lower as evidenced by mortgage delinquencies being lower in Canada (Exhibit 183). This was also true before challenges emerged in the US market.

 Personal loan covenants in Canada make it less attractive for borrowers to default on a mortgage. In Canada (with the exception of Alberta in many instances and Saskatchewan for low-LTV mortgages), mortgages contain personal covenants, such that if a borrower defaults on a mortgage and the mortgage loan is not recovered from the sale of the property, a mortgage lender has recourse to recoup the remaining loan balance from the borrower (e.g., through wage garnishments or claims on other assets, if a borrower defaults and the bank is still owed money). Having full recourse makes it very unlikely that an individual will default on a mortgage only based on house price depreciation, such as can be the case in many US states. Lender-recourse options in the US vary by state, with some states, for example, indicating that a mortgage lender must choose between pursuing the individual or the property for recourse.  Canadian banks compete only in the prime-mortgage space and do not offer mortgages to sub-prime borrowers. They offer mortgages where income is not fully verified, but those are small. (In Canada, mortgages originated by lenders regulated by the Bank Act (e.g., banks and trust companies) with LTV greater than 80% but at most 95% require mortgage insurance (which is paid for by the borrower), which protects the mortgage lender for the entire mortgage principal amount during the life of the mortgage. The 80% LTV threshold was increased from 75% on April 20, 2007.  Almost two-thirds of the banks’ residential mortgages are insured. Almost 80% of the mortgage-insurance market is provided by CMHC (based on insurance-in-force), an entity that is backed by the Government of Canada, and thus reduces counterparty non- payment risk for Canadian mortgage lenders.  In the US, mortgage insurance is required for all mortgages with an LTV greater than 80%, although the mortgage insurance does not insure the mortgage lender for the entire LTV percentage.  The sub-prime mortgage sector in Canada represents less than 5% of mortgage credit outstanding, which is lower than the 20% peak in the US, leaving Canada relatively less vulnerable should there be a downturn in the Canadian sub-prime mortgage markets.  Mortgage terms in Canada are significantly shorter than in the US. This situation allows mortgage lenders in Canada to reassess credit risk (and hence mortgage pricing) on the maturity of the mortgage term, typically after five years.  Uninsured mortgages are generally underwritten to hold, thereby increasing banks’ willingness to underwrite properly, which has led to banks underwriting mortgages almost entirely based on both property value and debt servicing capacity.  Canadian mortgage products are generally more conservative compared to the US, with an absence in the Canadian mortgage market of many of the more innovative and exotic mortgage products that were offered in the US.  Fixed-rate mortgage holders face prepayment penalties if they try to re-finance their mortgage to take advantage of lower interest rates.  Mortgage interest payments and mortgage insurance payments are not deductible for tax purposes in Canada, unlike in the US; therefore, Canadians have little incentive to keep mortgage balances high.

The prevalence of mortgage insurance and the structure of the mortgage-insurance market in Canada also reduce credit risk.

 In Canada, mortgages originated by lenders regulated by the Bank Act (e.g., banks and trust companies) with LTV greater than 80% but at most 95% require mortgage insurance (which is paid for by the borrower), which protects the mortgage lender for

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the entire mortgage principal amount during the life of the mortgage. The 80% LTV threshold was increased from 75% on April 20, 2007.  About 60% of banks’ residential mortgages are insured. Almost 80% of the mortgage- insurance market is provided by CMHC (based on insurance-in-force), an entity that is backed by the Government of Canada, and thus reduces counterparty non-payment risk for Canadian mortgage lenders.  In the US, mortgage insurance is required for all mortgages with an LTV greater than 80%, although the mortgage insurance does not insure the mortgage lender for the entire LTV percentage.

Exhibit 182: Canadian banks’ non-prime exposure is small and mostly for new immigrants

Residential Mortgages ($ millions) 2011 2012 Most recent Domestic Alt-A* Domestic Alt-A* Total Mortgages** % of Total BMO 3,900 5,700 89,025 6.4% BNS nmf nmf 207,743 n/a CM 600 n/a 148,768 n/a NA 508 621 34,798 1.8% RY n/a n/a 201,138 n/a TD 353 n/a 176,564 n/a Total 5,361 6,321 858,036 0.6%

* As of October 31, 2011 and October 31, 2012. **As of April 30, 2013. Source: OSFI, Company reports, RBC Capital Markets

Exhibit 183: Mortgage delinquencies in Canada are much lower than in the US

Delinquency Delinquency rate (>90days) 0% Sep-90 Sep-93 Sep-96 Sep-99 Sep-02 Sep-05 Sep-08 Sep-11

Canada U.S.

As of June 30, 2013. Source: Canadian Bankers Association, Mortgage Bankers Association, RBC Economics, RBC Capital Markets

Interest-rate risk is easier to manage in Canada due to shorter mortgage terms and prepayment penalties.

Shorter mortgage terms in Canada make for easier asset-liability matching and reduce interest-rate risk. In the US, the mortgage term and amortization periods are often the same (e.g., a 30-year mortgage term is also amortized for 30 years). In comparison, the mortgage term and amortization in Canada are usually different (e.g., mortgage terms of up to 10 years, although five years is the most common, with the mortgage loan payments based on an amortization period of typically 25–30 years).

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 Interest-rate risk is reduced because it is easier for a Canadian mortgage lender to match a five-year mortgage loan with the sale of a five-year investment security (i.e., a BA or a GIC) than it would be for a US lender to fund a 30-year mortgage loan with a liability of similar maturity.

Prepayment penalties on fixed rate mortgages are more punitive in Canada than in the US. In Canada, prepayment penalties (for prepayments in excess of permitted limits, which typically range between 10% and 15%, but some mortgages offer prepayments up to 30% typically in the context of a borrower trying to take advantage of lower interest rates to refinance a mortgage) tend to be more punitive for the borrower, which in many cases makes it uneconomical to refinance a mortgage at a lower interest rate. In most cases, the prepayment penalty is the higher of three months’ interest or the present value of the interest-rate differential.

 Prepayment provisions in the US exist (particularly for sub-prime mortgages), but they are often more lenient than in Canada; in many cases, borrowers face no prepayment penalties, making it much easier to take advantage of lower interest rates, which hurts the banks because it drives down asset yields.  Because most mortgages in Canada have a set duration, this allows mortgage lenders to fund themselves with similar maturities. The punitive prepayment penalties in Canada mean that the banks do not see asset yields decline faster than funding costs when interest rates decline.

Lending standards were looser in the US compared to Canada Lending standards and criteria in Canada have been tighter than in the US. Loose lending standards in the US led to mortgages being granted to individuals who were not credit worthy and allowed for increased mortgage fraud; the two combined ultimately to increase default rates and credit losses.

 We believe that the relaxing of lending standards in the US prior to the crisis was partly due to insatiable investor demand for high-yielding securities, including those backed by residential mortgages. In order to meet this demand, we believe it is likely that lending standards were relaxed and new mortgage products were offered to attract borrowers who would otherwise not qualify for a mortgage.  It is likely that lending standards would have been much tighter and more strictly enforced if mortgage originators kept the mortgages on their balance sheet (instead of selling them via securitization conduits) and hence assumed all credit and default risk.  The ability to offload most of the credit and default risk, coupled with the insatiable investor demand for mortgage-backed securities, is likely a key reason that close to two- thirds of total mortgages were securitized in the US, which is higher than the one-third peak in Canada.

The Canadian government made changes to rules for government-backed insured mortgages on four separate occasions in the past five years to strengthen lending standards, which we think was done to help contain potential risks to the housing market including price growth related to speculation and households becoming overextended.

 The fourth and last round of changes to mortgage insurance rules were to help address the rise of household leverage in Canada, as household credit growth was slowing but the rate of the slowdown was likely not enough for the government (i.e., to a level similar to personal disposable income growth). The changes, which came into effect in July 2012 for new government-backed insured mortgages with loan to values of more than 80%, were to: 1) reduce the maximum amortization period to 25 years from 30 September 18, 2013 225 Canadian Bank Primer, Sixth Edition

years; 2) lower the maximum amount that Canadians can borrow in refinancing their mortgages to 80% from 85% of the value of their homes; 3) fix the maximum gross debt service ratio at 39% and total debt service ratio at 44%; and 4) limit the availability of government-backed insured mortgages to homes with a purchase price of less than $1 million.  Please refer to the mortgage-related sections in “SECTION 4: Retail banking is the largest earnings contributor” for greater detail.

US and Canadian tax systems are different Unlike in the US, mortgage-interest payments and mortgage-insurance premiums are not deductible for tax purposes in Canada. We believe that this gives US homeowners a greater incentive (compared to Canadians) to maximize the size of their mortgage in order to reduce the size of their income tax bill.

 Unlike in Canada, US homeowners are allowed to deduct mortgage-interest payments on their tax return, and in some cases, mortgage-insurance premiums can qualify for tax deductions. Furthermore, mortgage-interest payments can be deducted for up to two residences, subject to certain requirements.  This tax incentive, in effect, encourages US homeowners to borrow a greater amount and repay mortgage principal more slowly (i.e., build little in the way of home equity) to minimize their tax bill.

Capital requirements are low Basel II capital requirements provided material capital relief for mortgage holdings and did not change under Basel III. The risk weighting for uninsured residential mortgages declined to 10-15% from 50% for the Big Five Canadian Banks when they adopted Basel II, given that they operate under the Advanced Method. Insured residential mortgages (about two thirds of the banks’ mortgage holdings) have 0% risk weights. Many US banks operate under Basel I and would still be subject to 50% risk weightings.

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SECTION 12: Glossary and Acronyms Acceptances: A bill of exchange or negotiable instrument drawn by the borrower for payment at maturity and accepted by a bank. The acceptance constitutes a guarantee of payment by the bank and can be traded in the money market. The bank earns a ‘stamping fee’ for providing this guarantee.

Advanced internal ratings based approach (AIRB): A Basel II methodology to calculate credit risk capital requirements, which is determined by the banks using internal models and risk parameters such as historical loss experiences and expected losses, and is subject to regulatory (OSFI) approval. The other ‘standardized’ approach for calculating risk capital are based on prescribed capital charges or risk weights based on specific categories.

Allowance for credit losses (ACL): The amount deemed adequate to absorb identified credit losses as well as losses that have been incurred but are not yet identifiable as of the balance sheet date. This allowance is established to cover the lending portfolio including loans, acceptances, guarantees, letters of credit, and unfunded commitments. The allowance is increased by the provision for credit losses, which is charged to income and decreased by the amount of write-offs, net of recoveries in the period.

Alt-A mortgages: A type of mortgage where the borrower has a clean credit history but a lower credit score for reasons that make it impossible to borrow under standard underwriting conditions. Consequently, these mortgages contain non-conforming features, such as high-LTV ratios, and do not qualify under government-sponsored mortgage agency lending rules.

Amortized cost: A historical cost-based measure of an asset or liability, which is equal to the original cost plus or minus accumulated amortization of the discount or premium to original cost.

Assets-to-capital multiple (ACM): Total assets plus specified off-balance sheet items, as defined by the OSFI, divided by total regulatory capital. A higher number indicates greater leverage.

Assets under administration (AUA): Assets administered by a bank that are beneficially owned by clients. Services provided in respect of assets under administration are of an administrative nature, including safekeeping, collecting investment income, settling purchases, sale transactions, and record keeping.

Assets under management (AUM): Assets managed by a bank that are beneficially owned by clients. Services provided in respect of assets under management include the selection of investments and the provision of investment advice.

Asset-backed securities (ABS): Debt securities that are collateralized by the cash flows from a specified pool of underlying assets. Assets are pooled and securitized to make them available to a broader group of investors.

Asset-backed commercial paper (ABCP): Short-term money market security that is backed by assets (such as credit card or auto receivables) and issued by companies for short-term funding purposes, and mature within a year (typically 30–90 days).

Auction rate securities (ARS): Short-term debt instrument with a long-term maturity where the interest rate is regularly reset through a Dutch auction (a descending price auction that begins with the high asking price).

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Automated teller machine (ATM): Also called automated banking machine or ABM.

Available-for-sale (AFS) securities: All equity or debt securities must be classified as trading (fair value through profit or loss), designated at fair value (fair value option), or loans. AFS securities are measured at fair value, and unrealized gains and losses are included in other comprehensive income. AFS securities are reviewed regularly for evidence of non-temporary impairments that result in a decrease in estimated future cash flows of the instrument, with losses recognized through income.

Bankers’ acceptance (BA): Short-term debt instrument issued by a company and guaranteed by a bank. They can be traded on the secondary market and are often used as a money market instrument.

Basel committee on banking supervision (BCBS): A global committee to provide a forum for cooperation on banking supervisory matters. It seeks to enhance understanding key supervisory issues through information sharing, and develops guidelines and standards such as for capital adequacy. Committee members include Australia, Canada, China, France, Germany, Switzerland, the UK, the US, and many other countries. Basis point: One hundredth of a percentage point.

Capital: Consists of common shareholders’ equity, preferred shareholders’ equity and subordinated debentures. It can support asset growth, provide against loan losses, and protect depositors.

Cash earnings: Reported earnings excluding the amortization of intangibles (and goodwill historically), which is a non-cash expense.

Collateral: Assets pledged as security for a loan or other obligation. Collateral can take many forms, such as cash, highly rated securities, property, inventory, equipment, and receivables.

Collateralized debt obligation (CDO): Securitization of any combination of corporate debt, asset-backed securities, mortgage-backed securities, or tranches of other collateralized debt obligations to form a pool of diverse assets that are tranched into securities that offer varying degrees of risk and return so as to meet investor demand.

Collateralized loan obligation (CLO): Securitizations of any combination of secured or unsecured corporate loans made to commercial and industrial clients of one or more lending banks to form a pool of diverse assets that are tranched into securities that offer varying degrees of risk and return so as to meet investor demand.

Collective allowance: (previously referred to as the general allowance) is maintained to cover impairment in the existing credit portfolio that cannot yet be associated with specific credit assets. The collective allowance is assessed on a quarterly basis and a number of factors are considered when determining its level, including the long-run expected loss amount and management’s credit judgment with respect to current macroeconomic and portfolio conditions.

Commercial mortgage backed securities (CMBS): Securities created through the securitization of commercial, rather than residential mortgage loans. These securities are secured by loans on commercial properties.

Commercial paper: Short-term money market security that is issued by companies for short- term funding purposes that mature within a year (typically 30–120 days).

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Common equity Tier 1 ratio: reflects common shareholders’ equity less regulatory capital adjustments, divided by risk weighted assets.

Common shareholders’ equity: is the most permanent form of capital. Adjusted common shareholders’ equity is comprised of common shareholders’ equity less capital adjustments.

Core cash earnings: Cash earnings excluding unusual items.

Counterparty risk: is the potential for loss due to the failure of a borrower, endorser, guarantor or counterparty to repay a loan or honour another predetermined financial obligation.

Covered bonds: Full recourse on-balance sheet obligations issued by banks and credit institutions that are also fully collateralized by assets against which investors enjoy a priority claim in the event of an issuer’s insolvency.

Credit default swap (CDS): A credit derivative contract between two counterparties in which the seller agrees to make a payment to the buyer in the event of specified credit event (a default of a third party) in exchange for a fee or series of payments.

Credit derivatives: Off-balance sheet arrangements that allow one party (the beneficiary) to transfer credit risk of a reference asset, which the beneficiary may or may not own, to another party (the guarantor) without actually selling the asset.

Credit risk: Risk of financial loss due to a borrower or counterparty failing to meet its obligations in accordance with agreed terms. Credit exposure types include:

 Corporate: Defined as a debt obligation of a corporation, partnership, or proprietorship.  Bank: Defined as a debt obligation of a bank or bank equivalent (including certain public sector entities (PSEs) treated as bank equivalent exposures).  Sovereign: Defined as a debt obligation of a sovereign, central bank, certain multi development banks (MDBs) and certain PSEs treated as sovereign.  Securitization: On-balance sheet investments in asset-backed securities, mortgage backed securities, collateralized loan obligations and collateralized debt obligations, off- balance sheet liquidity lines to Bank’s own sponsored and third-party conduits, and credit enhancements.

Credit valuation adjustment (CVA): An adjustment reflecting the market value of counterparty credit risk inherent in a company’s assets under mark-to-market accounting. The adjustment accounts for netting and posted collateral between both parties.

Creditor insurance: Insurance purchased by a borrower to cover the balance owed to the bank in case of death or disability. Current replacement cost: The estimated cost of replacing derivative instruments that have a positive market value, thereby representing an unrealized gain to the bank.

Debt service burden: Debt-related payments (principal and interest) as a percentage of personal disposable income.

Debt valuation adjustment (DVA): An adjustment reflecting the market value of a company’s own credit risk inherent in its liabilities under mark-to-market accounting. This value is affected by the movement in a company’s credit spreads.

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Derivative: A contract between two parties, which requires little or no initial investment and where payments between the parties are dependent on the movements in price of an underlying instrument, index, or financial rate. Examples of derivatives include swaps, options, forward-rate agreements, and futures. The notional amount of the derivative is the contract amount used as a reference point to calculate the payments to be exchanged between the two parties, and the notional amount itself is generally not exchanged by the parties.

Dividend payout ratio: Shareholder dividends expressed as a percentage of net income. It represents how much of net income is returned to shareholders as dividends.

Domestic systemically important bank (B-SIB): A bank deemed by regulators systemically important to the domestic financial system, and who will need to hold more capital than peer banks who are not deemed D-SIBs.

Earnings per share (EPS): Basic EPS divides earnings by average shares outstanding, while diluted EPS divides earnings by adjusted average shares outstanding that includes dilutive stock options and other convertible securities.

EBITDA: Earnings before interest, taxes, depreciation, and amortization.

Economic capital: An estimate of the amount of equity capital required to underpin risks. It is calculated by estimating the level of capital that is necessary to support various businesses, given their risks, consistent with desired solvency standard and credit ratings. Economic capital typically includes a broader calculation of risks than regulatory capital, incorporates goodwill and intangibles, and considers diversification benefits across risk and business segments.

Euro zone: A group of 16 member states of the European Union that use the euro currency. Countries include Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Exposure at default (EAD): A calculation required by Basel’s credit risk reporting guidelines whereby the amount of exposure to a customer at the time of default must be estimated.

Fair value: The amount of consideration that would be agreed on in an arm’s-length transaction between knowledgeable and willing parties that are under no compulsion to act.

Forward rate agreement: An over-the-counter derivative where one party commits to receiving or paying a predetermined interest rate for a period of time starting at a specified date in the future.

Futures: Commitments to buy or sell designated amounts of commodities, securities, or currencies on a specified date at a predetermined price. Futures are traded on recognized exchanges. Gains and losses on these contracts are settled daily, based on closing market prices.

GAAP: Generally accepted accounting principles.

Global systemically important financial institutions (G-SIFIs): Financial institutions deemed by regulators as most important to the financial system, and who will need to hold more capital than medium and smaller-sized banks.

Gross domestic product (GDP): A country’s output or the value of goods and services produced by the economy. September 18, 2013 230 Canadian Bank Primer, Sixth Edition

Gross impaired loans (GIL) ratio: The percentage of total loans that is impaired. Loans are classified as impaired when the bank no longer has reasonable assurance of timely collection of the full amount of principal and interest on the loan.

Guaranteed investment certificate (GIC): A short term (usually 30 days to five years) deposit or debt instrument that pays a guaranteed interest rate. They are the US equivalent of certificates of deposits.

Hedging: is a risk management technique used to neutralize, manage or offset interest rate, foreign currency, equity, commodity or credit exposures arising from normal banking activities.

Held-to-maturity (HTM) securities: Under Canadian GAAP, debt instruments that a bank intended to hold until maturity. The classification no longer exists under IFRS.

Harmonized sales tax (HST): A sales tax in Canada used by several provinces that combine the federal goods and services tax (GST) and the provincial sales tax (PST), and it is charged on most goods and services.

Home equity line of credit (HELOC): A personal line of credit that is secured by the borrower’s home as collateral, typically with a variable interest rate.

Impaired loans: Loans are classified as impaired when there has been a deterioration of credit quality to the extent that management no longer has reasonable assurance of timely collection of the full amount of principal, and interest in accordance with the contractual terms of the loan agreement. Credit card balances are not classified as impaired since they are directly written off after payments are 180-days past due.

Impaired loan formations: The increase in gross impaired loans, offset by impaired loans that are repaid and returned to performing status

Innovative capital instruments: Capital instruments issued by special-purpose entities (SPEs), whose primary purpose is to raise capital.

IFRS: International Financial Reporting Standards. Canadian banks converted to IFRS (from Canadian GAAP) in fiscal 2012.

Interest-only strip: A financial instrument that is entitled to only the interest payments off a pool of interest bearing assets underlying it. The value of the interest-only strip declines over time as the underlying principal is gradually paid off.

Leverage ratio: Balance sheet leverage is typically equity divided by assets. Tier 1 leverage is equal to Tier 1 capital divided by total exposure (including off balance sheet exposures) net of specified deductions.

LIBOR (London interbank offered rate): The London interbank offered rate is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market.

Liquidity and funding risk: Risk of having insufficient cash resources to meet current financial obligations without raising funds at unfavourable rates or selling assets on a forced basis.

Liquidity coverage ratio (LCR): a new regulatory liquidity requirement to help ensure that banks have enough liquid assets to survive a period of time with no access to outside funds. The LCR will be introduced in 2015. September 18, 2013 231 Canadian Bank Primer, Sixth Edition

Loss given default is an estimate of loss after recoveries on a loan that would go in default. In a deteriorating economy, recovery rates tend to deteriorate as asset values drop.

Management expense ratio (MER): a mutual fund’s annual fees and expenses as a percentage of assets.

Mark-to-market (MTM): An adjustment of the value of a security position to its current market value.

Market risk: The potential for financial loss from adverse changes in underlying market factors, including interest and foreign exchange rates, credit spreads, and equity, and commodity prices.

Master netting agreement: An agreement between a bank and a counterparty designed to reduce the credit risk of multiple derivative transactions with the creation of a legal right of offset of exposure in the event of a default.

Medium-term notes (MTN): A corporate-debt instrument that generally matures in three to 10 years.

M&A: Mergers and acquisitions

Net-impaired loans (NIL) ratio: Gross-impaired loans net of specific and general allowances (reserves) expressed as a percentage of loans.

Net interest income: The difference between what is earned on assets such as loans and securities and what is paid on liabilities such as deposits and subordinated debentures.

Net interest margin (NIM): Net interest income, on a taxable equivalent basis, expressed as a percentage of average total assets.

Net stable funding ratio (NSFR): a regulatory ratio requirement that would likely lead to lower duration mismatches between assets and liabilities primarily by leading to banks extending the term of their liabilities. The ratio would likely be phased in by 2018.

Non-interest expense (NIE): Operating expenses that are mostly comprised of compensation costs, but infrastructure costs such as premises, information technology, and communications are also important components.

Non-interest income: Also referred to as ‘other’ income and fee income, it represents revenues that are not generated from interest income.

Normal course issuer bid (NCIB): An open-market share repurchase program executed through a stock exchange that is typically done for stock cancellation.

Notional amount: The contract amount used as a reference point to calculate payments for derivatives.

OSFI (Office of the Superintendent of Financial Institutions): Canada’s primary regulator of federally chartered financial institutions, including banks, insurance companies, and trust companies.

Off-balance sheet financial instruments: A variety of credit-related arrangements offered to clients, which generally provides liquidity protection.

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Operational risk: The risk of loss resulting from inadequate or failed internal processes, systems, or from human error or external events.

Operating leverage: Revenue growth less expense growth, on a year-over-year basis.

Options: A contract or a provision of a contract that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms.

Other comprehensive income (OCI): OCI does not affect earnings but rather affects shareholders’ equity in a given reporting period arising from certain transactions and events such as unrealized gains and losses on AFS securities or on foreign currency translation, and it is accumulated in the shareholders’ equity section of the balance sheet.

P/B: Price-to-book value multiple.

P/E: Price-to-earnings multiple.

Primary dealer: A status given to a bank or investment dealer that allows them to trade directly with a country’s central bank.

Prime jumbo mortgages: A mortgage that is too large to qualify under US government- sponsored mortgage agency lending rules although the borrower has a clean credit history.

Probability of default is a calculation required by Basel’s credit risk reporting guidelines of the likelihood of a loan not being repaid with higher probabilities of default in a deteriorating economy.

Provision for credit losses (PCL): is a charge to income that represents an amount deemed adequate by management to fully provide for impairment in a portfolio of loans and acceptances and other credit instruments, given the composition of the portfolio, the probability of default, the economic environment and the allowance for credit losses already established.

Provision for credit loss (PCL) ratio: The income statement effect of increasing (or decreasing) allowances for credit losses, expressed as a percentage of loans.

Productivity ratio (or efficiency ratio): Measures the efficiency with which a bank incurs expenses to generate revenue. It expresses NIE as a percentage of the sum of net interest income on a taxable equivalent basis and other income. A lower ratio indicates a higher gross margin.

Registered retirement income fund (RRIF): A tax savings plan for Canadians who are nearing the age of 71 and can no longer shelter taxes through a registered retirement savings plan. Taxpayers can convert registered funds into a RRIF before a taxpayer turns 71, and the funds are intended to provide a steady income stream that incurs lower taxes than when the funds were contributed.

Registered retirement savings plan (RRSP): A savings plan that allows investments to be tax sheltered until retirement or a maximum age of 71. Canadian taxpayers can make limited contributions each year for an income tax deduction and income earned in an RRSP is not taxable unless funds are withdrawn.

Regulatory capital: Regulatory capital comprises Tier 1 and Tier 2 capital as defined by OSFI’s Capital Adequacy Regulations. Tier 1 capital is comprised of common shares, retained September 18, 2013 233 Canadian Bank Primer, Sixth Edition

earnings, qualifying Tier 1 instruments, and certain other elements. Tier 2 capital is composed of qualifying subordinated indebtedness, qualifying general allowances, and certain other elements. Total capital is the sum of Tier 1 and Tier 2 capital, less certain specified adjustments.

Repurchase agreements: Involve the sale of securities for cash at a near-value date and the simultaneous repurchase of the securities for value at a later date.

Residential mortgage-backed securities (RMBS): Securities created through the securitization of residential mortgage loans.

Return on assets (ROA): ROA is measured as net income divided by assets. It is a measure of net-income margins on an unlevered basis.

Return on equity or return on common shareholders’ equity (ROE): is calculated as net income, less preferred dividends, as a percentage of average common shareholders’ equity. Common shareholders’ equity is comprised of common share capital, contributed surplus, accumulated other comprehensive income (loss) and retained earnings.

Return on risk-weighted assets: RORWA is measured as net income divided by risk-weighted assets. It is a measure of net-income margins on an unlevered basis, and it attempts to take the risk of assets into consideration.

Reverse repurchase agreements: Involve the purchase of securities for cash at a near-value date and the simultaneous sale of the securities for value at a later date.

Risk-adjusted assets (or risk-weighted assets): As prescribed by the OSFI guidelines and used in the calculation of risk-based capital ratios. The face value of on-balance sheet assets is discounted using specified risk-weighting factors that reflect the relative risk of the asset. The risk inherent in off-balance sheet instruments is also recognized, first by determining a credit equivalent amount, and then by applying appropriate risk-weighting factors. Risk- weighted assets also consider operational and market risk.

Securitization: The process by which financial assets are packaged into newly issued securities backed by these assets. Securitizations allow banks to diversify their funding sources.

Special purpose entities (SPEs): Entities that are typically organized for a single discrete purpose, have a limited life and serve to isolate the financial assets held by the SPE from the selling organization legally. SPEs are principally used to securitize financial and other assets in order to obtain access to funding, to mitigate credit risk, and to manage capital.

Specific allowances: reduce the carrying value of specific credit assets to the amount a bank expects to recover if there is evidence of deterioration in credit quality.

Standardized approaches for capital requirements: A Basel II methodology to calculate risk capital, based on prescribed capital charges or risk weights based on specific categories. This is in contrast to advanced approaches that require a bank to use internal models and risk parameters to calculate risk capital.

Structured investment vehicle: Managed investment vehicle that holds mainly highly rated debt and asset-backed securities and funds itself using the short-term commercial paper market as well as the medium-term note (MTN) market.

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Sub-prime loans: Sub-prime lending is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. Sub-prime lending carries more risk for both lenders and borrowers due to the combination of higher interest rates, poorer credit histories, and adverse financial situations usually associated with sub-prime applicants.

Swaps: Interest-rate swaps are agreements to exchange streams of interest payments, typically one at a floating rate, the other at a fixed rate, during a specified period of time, based on notional principal amounts. Cross-currency swaps are agreements to exchange payments in different currencies during pre-determined periods of time.

Synthetic securitization: The transfer of risks relating to selected elements of financial assets to unaffiliated third parties by the use of certain financial instruments such as credit-default swaps and guarantees.

Tangible common equity (TCE) ratio: The TCE ratio is a ratio of TCE to risk-weighted assets. Tangible common equity is total shareholders’ equity plus non-controlling interest in subsidiaries, less preferred shares, unamortized goodwill and intangible assets (net of taxes).

Taxable equivalent basis (TEB): A non-GAAP measure in which tax-exempt income, such as US municipal bond income held by US-based businesses, is grossed up to help the comparison against income that is subject to taxes. An offsetting adjustment in the tax provision is made to generate the same after-tax net income.

Tier 1 capital and Tier 1 capital ratio: Tier 1 capital is considered to be permanent in nature without creating a fixed charge against income. As defined by the OSFI, it includes common equity, retained earnings, and qualifying non-cumulative preferred shares, and innovative capital instruments. The Tier 1 capital ratio is calculated by dividing Tier 1 capital by risk- adjusted assets.

Total capital ratio: The percentage of risk-adjusted assets supported by capital using the guidelines of the OSFI based on standards issued by the Bank for International Settlements and Canadian GAAP financial information.

Trading securities (fair value through profit or loss, FVTPL): Securities purchased and intended for sale near term. Realized and unrealized gains and losses are recorded as non- interest income trading revenue, while dividends and interest income are recorded as interest income.

Trading-related revenues: Include net interest income and non-interest revenue earned from on- and off-balance sheet positions undertaken for trading purposes. The management of these positions typically includes marking them to market on a daily basis. Trading related revenues include income (expense) and gains (losses) from both on-balance sheet instruments and interest rate, foreign exchange (including spot positions), equity, commodity and credit contracts.

Value-at-risk (VaR): A generally accepted risk-measurement concept that uses statistical models based on historical information to estimate within a given level of confidence the maximum loss in market value that a bank would experience in its trading portfolio from an adverse one-day movement in market rates and prices. VaR is the best available measure for outsiders to determine market risk.

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Variable interest entity (VIE): An entity which either does not have sufficient equity at risk to finance its activities without additional subordinated financial support, or where the holders of the equity at risk lack the characteristics of a controlling financial interest.

Wrap: Fund wraps, a type of ‘fund-of-fund’ product, are fee-based products which invest in a variety of underlying mutual funds. Wrap products are often administered by professional money managers, who are responsible for rebalancing activities.

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Exhibit 184: Global Financials Research Team Canadian Financials Wes Golladay (Analyst) (440) 715-2650 [email protected] RBC Dominion Securities Inc. Mike Salinksy (Analyst) (440) 715-2648 [email protected] Canadian Banks and Insurance Neil Malkin (Associate) (440) 715-2651 [email protected] André-Philippe Hardy (Analyst) (416) 842-4124 [email protected] Robert Poole (Associate) (416) 842-5638 [email protected] US P&C Insurance Michael Loewen (Associate) (416) 842-7815 [email protected] Mark Dwelle (Analyst) (804) 782-4008 [email protected] Scott Heleniak (Associate) (804) 782-4006 [email protected] Canadian Asset Managers, Mortgage Cos and Other US Life Insurance and Asset Management Geoffrey Kwan (Analyst) (604) 257-7195 [email protected] Eric Berg (Analyst) (212) 618-7593 [email protected] Charan Sanghera (Associate) (604) 257-7657 [email protected] Bulent Ozcan (Associate Analyst) (212) 863-4818 [email protected] Anthony Jin (Associate Analyst) (416) 842-5338 [email protected] Kenneth Lee (Associate) (212) 905-5995 [email protected] Canadian REITs Neil Downey (Analyst) (416) 842-7835 [email protected] European Financials, RBC Europe Limited Kevin Cheng (Associate) (416) 842-3803 [email protected] European Banks Matias Ronis (Associate) (416) 842-7894 [email protected] Fiona Swaffield (Analyst) 44 207 029 0785 [email protected] Ben Halm (Associate) (416) 842-8720 [email protected] Anke Reingen (Analyst) 44 207 029 0784 [email protected] US Financials Claire Kane (Analyst) 44 207 029 0864 [email protected] RBC Capital Markets, LLC Patrick Lee (Analyst) 44 207 002 2258 [email protected] US Banks (East Coast) Robert Noble (Analyst) 44 207 029 0786 [email protected] Gerard Cassidy (Analyst) (207) 780-1554 [email protected] Adrian Cighi (Associate) 44 207 029 0866 [email protected] Jake Civiello (Analyst) (617) 725-2152 [email protected] European Insurance Steven Duong (Associate) (207) 780-1554 [email protected] Gordon Aitken (Analyst) 44 207 002 2633 [email protected] John Hearn (Associate) (207) 780-1554 [email protected] Paul De’Ath (Associate) 44 207 029 0761 paul.de’[email protected] US Banks (Central/Midwest) Kamran Hossain (Associate Analyst) 44 207 029 0847 [email protected] Jon Arfstrom (Analyst) (612) 373-1785 [email protected] European Diversified Financials Andy Hedberg (Associate) (612) 371-2709 [email protected] Peter Lenardos (Analyst) 44 207 029 0824 [email protected] US Banks (West Coast) Portia Patel (Associate) 44 207 029 0823 [email protected] Joe Morford (Analyst) (415) 633-8518 [email protected] Jeannette Daroosh (Associate) (415) 633-8572 [email protected] Financials – Credit Research Joseph Walsh (Associate) (415) 633-8567 [email protected] Canadian Investment Grade, RBC Dominion Securities Inc. US Specialty Finance Altaf Nanji (Analyst) (416) 842-6462 altaf. [email protected] Jason Arnold (Analyst) (415) 633-8594 [email protected] Vivek Selot (Associate) (416) 842-5165 [email protected] Andy Ellner (Associate) (415) 633-8688 [email protected] US Investment Grade (Bank and Finance), RBC Capital Markets, LLC Taylor Hamilton (Associate) (415) 633-8551 [email protected] Ian Jaffe (Analyst) (212) 858-7317 [email protected] US REITs Michael McTamney (Associate) (212) 858-7258 [email protected] Rich Moore (Analyst) (440) 715-2646 [email protected] Europe and U.K. Investment Grade, RBC Europe Limited Michael Carroll (Analyst) (440) 715-2649 [email protected] Carlo Mareels (Analyst) 44 207 653 4386 [email protected]

September 18, 2013 237 Canadian Bank Primer, Sixth Edition

Required Disclosures Non-U.S. Analyst Disclosure Andre-Philippe Hardy, Robert Poole and Michael Loewen (i) are not registered/qualified as research analysts with the NYSE and/ or FINRA and (ii) may not be associated persons of the RBC Capital Markets, LLC and therefore may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Conflicts Disclosures This product constitutes a compendium report (covers six or more subject companies). As such, RBC Capital Markets chooses to provide specific disclosures for the subject companies by reference. To access current disclosures for the subject companies, clients should refer to https://www.rbccm.com/GLDisclosure/PublicWeb/DisclosureLookup.aspx?entityId=1 or send a request to RBC CM Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, South Tower, Toronto, Ontario M5J 2W7.

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weeks, based on market and trading events. A Short-Term Trade Idea may differ from the price targets and/or recommendations in our published research reports reflecting the research analyst's views of the longer-term (one year) prospects of the subject company, as a result of the differing time horizons, methodologies and/or other factors. Thus, it is possible that the security of a subject company that is considered a long-term 'Sector Perform' or even an 'Underperform' might be a short-term buying opportunity as a result of temporary selling pressure in the market; conversely, the security of a subject company that is rated a long-term 'Outperform' could be considered susceptible to a short-term downward price correction. Short-Term Trade Ideas are not ratings, nor are they part of any ratings system, and RBC Capital Markets generally does not intend, nor undertakes any obligation, to maintain or update Short-Term Trade Ideas. Short-Term Trade Ideas discussed in SPARC may not be suitable for all investors and have not been tailored to individual investor circumstances and objectives, and investors should make their own independent decisions regarding any Short-Term Trade Ideas discussed therein. Analyst Certification All of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all of the subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report.

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