Gordon M. Nixon
President & Chief Executive Officer
Royal Bank of Canada
Canada-UK Chamber of Commerce
November 16, 2009
Good afternoon ladies and gentlemen — thank you Mike, for that kind introduction and for giving me the honour to speak with you again.
It was almost a year ago, to the day, that Bank of Canada Governor Mark Carney delivered to this luncheon remarks about the directions of reforms required for the global financial system. We find ourselves today having made much progress but with much still in front of us in terms of the rules, regulations and operating models of the world's financial institutions.
Today, I would like to comment on some of the differentials for Canada and RBC but, more importantly, discuss the impending regulatory reforms that seek to mitigate a future crisis on our economies and the global banking sector. While this may seem like a somewhat dull topic, it is of critical importance not just to the financial system but to the foundation of our economy and everyone in this room.
As you might expect, I have a bias towards a regulatory model that finds the right balance between risk and reward while enabling the banking industry to not only grow and thrive but to act as a catalyst for economic growth, innovation and capital formation.
It is critical, in my view, that, — as a result of the mistakes that led the financial system to the edge of the abyss — that we not put in place new rules and regulations that impede the ability of the market to operate efficiently.
Now because this is the Canada/UK Chamber, I will start by providing perspective on why Canada and our banking system performed much better than others during this crisis (particularly compared to those in the U.S. and the U.K.). But before doing so, I would like to refresh your knowledge about RBC.
Today, we are the 13th largest bank in the world by market capitalization. As a matter of interest the last time I spoke with you in April 2006, we ranked 27th — and that was in a universe of banks that is dramatically different than today. I wish we had moved up the rankings for reasons other than the general decline of the industry, but nonetheless we are one of the world's largest and most profitable financial institutions.
We are a diversified financial company with five business platforms: Canadian Banking, International Banking, Insurance, Wealth Management and Capital Markets. We have operations in 55 countries around the world with approximately 80,000 employees serving 18 million clients. In Europe we have approximately 3000 employees with about 1500 in London mostly in our Global Capital Markets and Wealth Management divisions.
The scale of our operations continues to grow and this year we were proud to be voted best overall credit house in Europe in "Credit Magazine's 2009 European Credit Awards", "Employer of the Year" by the City of London Corporation and recognized by Private Banker International with its award for "Outstanding Private Bank in North America. Unlike many who were pulling back from the market we are continuing to invest and are not only gaining recognition but market share as well. I might note that we were selected a couple of weeks ago as one of three joint book runners on the UK Government 7 billion Gilt issue, a testament to the strength of our global fixed income business.
With that backdrop, I would like to put into perspective why the Canadian banking system outperformed during what was a global financial crisis, particularly given the global nature of our businesses.
I should say at the outset that we were not without our challenges in Canada. The non-bank asset-backed commercial paper market was a 35 billion dollar issue that our system and markets had to manage through and, with respect to individual performance, some Canadian banks faced significant challenges in terms of write-downs and financial results.
In our case, we managed to be very profitable through the crisis, notwithstanding significant mark to market losses and a stressed U.S. retail bank. But regardless of individual performance, the Canadian system, as a whole, performed extremely well with no bailouts or government support required beyond central bank and government financing programs that were instituted on market terms.
While there are several reasons for the success of Canadian banks, I'd like to focus my discussion on three broad themes:
With regards to good fundamentals, the IMF recently stated that Canada is better placed than many countries to weather the global financial turbulence and worldwide recession: Its expectations are that Canada's economic growth in 2010 will be stronger than any other G7 country.
The Canadian economy has not been immune from the global economic downturn, but it has been insulated by a foundation of sound macroeconomic policies and a strong monetary framework.
Heading into the crisis, Canada ran 11 straight years of fiscal surpluses, giving Canada the lowest net debt to GDP ratio in the G-7.
As noted by the BBC's Economics Editor, Stephanie Flanders, the sober management of Canada's public finances left room for a decent-sized stimulus package, which led her to call Canada a "goodie two-shoes" economy.
Today, the combination of accommodative monetary and fiscal policy is pulling the Canadian economy from recession slowly and delicately. But equally important is that our strong fundamentals have muted the impact of the global and Canadian recession on our markets, companies and individual Canadians when compared to countries like the United Kingdom.
The fiscal challenges that Canada had in the 1980s and early 1990s, resulted in the Canadian public recognizing the importance of balanced budgets and, politically, fiscal discretion was embraced, which was not the case for many other G8 countries and, particularly, the United States.
Fiscal prudence was a major differential for Canada going into the crisis and will, hopefully, be a major differentiator coming out.
Conservative risk appetite
The conservative risk profile of Canadian banks is becoming increasingly well known and respected. In addition, Canada's banks are generally well diversified geographically and across business lines.
Despite having a leading global capital markets business with significant operations in Toronto, New York and London, RBC has been a more conservative participant in markets for the more exotic instruments than many of our global counterparts. Our structured credit business in London, for example, experienced major write-downs but its size and scale relative to our capital base and balance sheet made it manageable. Our strategic objective is for our wholesale operation to represent between 20% — 30% of our normalized business and we worked hard to maintain that balance even when excess liquidity as accommodative markets made it easy to aggressively grow wholesale assets.
Most major Canadian banks demonstrated notable capacity for being profitable even during the peak of the global economic crisis and our banks have historically carried higher levels and better quality capital than their global counterparts with less leverage across all parts of the system.
In addition, all of the major Canadian banks have a national distribution network — RBC's is the largest — with a strong deposit base that makes us less dependent on wholesale funding. We also have a diversified, global funding strategy which reduces our costs and makes us less reliant on funding from one single source.
This is not to say that Canadian banks are unblemished by the crisis: As a result of the financial crisis, they have had cumulative write-downs of 22 billion dollars from the second quarter of 2007 to the end of the third quarter of this year. But when measured as a percentage of book value or earnings, these levels are dramatically lower than banks in the U.S., Europe and the U.K.
This individual and collective performance prompted both Moody's and the World Economic Forum to declare Canada as home to the world's soundest banks in each of the past two years. By contrast, the World Economic Forum ranked the banking systems in the U.K. and U.S. at 126th and 108th, respectively, out of 133 countries.
Sound regulatory regime
The third characteristic of Canadian banks is a sound regulatory regime which requires proactive management and monitoring of capital levels and leverage.
While Basel II requires Tier 1 and total capital ratios of 4 per cent and 8 per cent respectively, Canadian banks are required by our lead regulator to hold at least 7 per cent and 10 per cent, respectively.
As at the end of our third quarter, RBC's Tier 1 capital ratio was 12.9 per cent, significantly higher than our regulatory minimums and stronger than most of our global peers. Importantly, our tangible common equity ratio was 9.1 per cent and while Tier 1 is important, there is nothing like bedrock common equity.
In the short term, I believe it is important to be conservatively capitalized — and clearly, at this level, we carry capital well above the regulatory minimums. But in this market, our capital strength provides us with a competitive advantage along with substantial flexibility to both grow and maintain our dividends.
We have tremendous opportunities to invest in our existing businesses and toward other opportunities consistent with our corporate strategy. Over time, our ratios are likely to trend down slightly as we take advantage of attractive ways to deploy capital but in this period of economic and regulatory uncertainty it is prudent to keep them high. This is, however, in contrast to much of our global competition, particularly in Europe, which will be required to significantly increase core-capital and decrease balance sheet leverage to meet future regulatory requirements.
Quality of capital is only one side of the equation, with leverage being the other. I believe that excessive leverage was perhaps the greatest contributing factor to the problems at many banks because capital rules risk-adjust assets and the assets that caused such stress in many banks were "highly rated assets" therefore, requiring very little capital. If you are levered at 50 to one, it doesn't take much of a decline in your asset values to wipe out your equity and that is exactly what happened to many banks, particularly in Europe.
RBC and other Canadian banks operate under a binding constraint on our leverage. The leverage at RBC — while amongst the highest in Canada — is very low relative to many banks around the world. Since the start of this decade the rate of growth of assets at many banks was significantly higher than the rate of growth of capital a trend that played a great part in the collapse of many financial institutions.
Another contributing factor to the success of the Canadian banking system is that we have a more conservative domestic housing market.
While there were many causes of the financial crisis, and blame can be shared by politicians, regulators, financial institutions, credit rating agencies and investors, the primary cause of the crisis was a massive failure of public policy and regulation in the U.S. residential real estate market which initiated and significantly contributed to the financial crisis.
Canadian rules require bank-originated mortgages with a loan-to-value ratio greater than 80 per cent to be insured. Canadian consumers are discouraged from carrying excessive debt as mortgage interest is not tax-deductible, and our mortgage products are typically for five-year terms with 25-year amortization periods. There are no teasers or hybrids, and prepayment penalties discourage refinancing booms.
Further, in Canada the majority of mortgages outstanding are held on the balance sheet of the originators, whereas in the U.S. the majority of mortgages are securitized and held off the originators balance sheet.
What was the worst performing asset class in the United States and other countries was one of the best in the Canadian system. Importantly, however, I would note that from a public policy perspective, while our market is more conservative, the rate of homeownership in Canada is comparable to the U.S.
In summary, there were a number of factors that sheltered the Canadian banking system from the fate of others but the structure of the system was able to weather the storm and our governance structure should be an example to others.
With that brief overview, let me turn more specifically to the challenges facing our industry today.
As policymakers talk through potential reforms at the G-20 table and in other forums, they must commit to a prudent set of rules that resist the temptation for over-regulation while at the same time end the perception that there are institutions that are too big to fail, and restore both accountability and risk of bank performance to management, creditors and shareholders. It is a tricky balance but critical to the functioning of not just the financial system but the economy in general.
As was made clear by Canadian regulators recently, market discipline must be re-asserted in the financial services sector, lest companies take on more risk than optimal. In addition, our regulators have been consistent in saying that failure of institutions should be a viable option in a global framework, and that there must be penalties for any failure.
The underlying approach to the Canadian regulatory model is principles-based — relying on the judgment of management and advisors of institutions, rather than the "security blanket of excess capital." Such a system demands that good risk management and governance become embedded in all operations of a company, not merely exercises to satisfy a compliance checklist.
This view reflects the value of companies creating integrated and disciplined risk management programs. At RBC, our enterprise risk management activity is led by our Chief Risk Officer who reports directly to me. Our risk management framework is built on a foundation of a strong risk management culture, supported by a robust enterprise-wide set of policies, procedures and limits that involve our risk management professionals, business segments and other functional teams. This cross-enterprise partnership is designed to ensure the ongoing alignment of business strategies and activities within our risk appetite.
Clearly, from our experience and that of the Canadian sector, a model based on good governance and prudent management works well to mitigate risk while promoting market competitiveness, functioning and efficiency.
Industry leaders, policymakers and those drafting regulatory reforms must recognize that the financial system is more about confidence and perception than technical measures of liquidity and solvency. While living wills and other wind down mechanism are worth discussing, these kinds of measures will not work in isolation if we have a systemic meltdown like we did in the Fall of 2008. At the height of the crisis, when Lehman went down, others would have followed regardless of their liquidity or level profitability because the market viewed balance sheets as too large and illiquid relative to capital under-pinning. Regulators must ensure that within their National Markets that institutions are sufficiently capitalized and manage their risk sufficiently to prevent a collapse from a market and economic crisis because they will inevitably occur. Good international regulation has to start with good local regulation.
But because a financial instrument created in one jurisdiction often relies on counterparties in another, there is an imperative for regulators to coordinate monitoring and response, and to ensure markets are continuously available. The past crisis, which showed an unexpected speed and severity of the financial contagion, proved that every country has a vested interest in an internationally coordinated effort to create a more sustainable financial framework.
To avoid a similar meltdown and to ensure future competitive markets, we need better and more consistent national regulation alongside global oversight and cooperation.
Further, the impact of adopting future reforms without global coordination will be felt in the reduced competitiveness of markets and, perhaps more importantly, stifled economic growth.
With this in mind, I want to point out developments that I find concerning and counterproductive to instilling confidence in the global financial system. These developments could, in my view, undermine effective regulation and the global banking sector's ability to facilitate economic prosperity.
First, a common theme of most reform initiatives being considered is increased capital requirements. Higher capital requirements are required. However, I am concerned that too much emphasis on individual reforms and prescriptive rules will outweigh consideration of their cumulative impact and their cost to institutions.
Given the scope of the crisis and public demands for redress, the agenda for regulatory change is ambitious and, in the case of many proposed initiatives, still at a fairly conceptual stage. Policymakers must resist the temptation to see over-regulation as a panacea for future crisis.
In addition, they must be cognizant of the risks of unintended consequences of too much change being implemented over a short period of time.
Higher minimum levels of both Tier 1 capital and Tangible Common Equity should be mandatory but the levels should be standard, straight forward and reflect the appropriate risk/reward of business. We should avoid the "piling on effect" that could result from regulatory or policy makers in different jurisdictions wanting to impose their own specific requirements.
Regulators are discussing minimum capital levels, premiums for systemically important institutions, deducting goodwill from core equity, eliminating the value of deferred taxes, significant increase for operating risk capital, special financial transaction taxes, reducing the ability of institutions to manage capital globally, counter cyclical capital level mechanisms and the list goes on.
We must remember that for the financial industry to maintain its market confidence and credit ratings — it must be able to generate reasonable returns. The cost of higher equity levels and inefficient regulation will ultimately be passed on in the form of higher credit cost and it is, therefore, important to ensure that regulation doesn't overreact and choke off economic growth.
Implementing reforms that are not fully thought through pose stark risks to the industry and the financial system itself. Whatever direction reforms take, they must be straight forward, easily understood and not vulnerable to misinterpretation or manipulation.
I have strong concerns that reforms may be implemented in different jurisdictions along uneven and uncoordinated timelines. Reforms implemented at different times by different regulators create competitive disadvantages for banks under the purview of early adopting regulators. Consistency and a level playing field must, in my view, be a core principle or the world can be held hostage to the lowest common denominator. I believe banks in different jurisdictions are operating under different assumptions and would encourage constant standards across the G20.
International harmonization, of specific regulations — such as liquidity and capital standards — and their implementation timelines, is critical to ensuring the marketplace functions efficiently.
The other area where there seems to be differing views is on maximum leverage ratios. Again, in my view, it is essential that we have consistent international regulations that cap leverage ratios at levels that reduce the risk of crisis from inflated and illiquid balance sheets. When you look at the ratio between capital and assets of some banks since the beginning of the decade it is staggering and the banks that aggressively grew assets — in many cases irrespective of return on those assets — were those that were most exposed when the crisis hit.
We need time to allow institutions to get to a common level but, in my view, it is essential that there is an international standard that caps leverage relative to core equity. Capital formulas — on their own — did not work last time….so why should they next time.
As I understand the fundamental objective of the G-20 discussions, reforms should create a global financial system that supports worldwide economic growth and confidence in the financial system.
In considering new rules, authorities should, in my view, embrace the following principles:
Any new rules and regulations should seek to create a level playing field for all global institutions.
There must be co-operation and agreement to arrive at internationally accepted definitions and requirements for capital and liquidity, and the timing of their implementation.
We should avoid overly complicated formulas or special surcharges or taxes that will stifle growth.
Tier 1 capital and tangible common equity standards should be increased but they should be determined as a result of collaboration among global regulators to achieve a coordinated and harmonized implementation plan that does not over price credit and choke off economic growth.
And leverage ratios of financial institutions should be capped at levels that prevent a systemic collapse from a decline in asset values.
I will conclude this afternoon by saying that the fallout from the historically significant events of the past two year's demands thoughtful response.
From my point of view, any reform must fit into a framework that balances risk and reward while enabling the banking sector to succeed and facilitate economic growth, innovation and capital formation.
Now is not the time to be tempted to score political points and hastily implement new rules and regulations that impede the ability of the market to operate efficiently. Compensation principles must be aligned with risk taking but compensation was not the cause of the financial crisis.
Policymakers must find a way to resolve the need for reforms with a globally agreed upon solution. The last two years of crisis and instability have taught us well that the interdependencies of the financial sector span all borders.
I urge regulators and policymakers to see to it that we are equally interconnected when it comes to setting the stage for prosperity.
Thank you for inviting me.