CIBC’s blockbuster deal and the ghosts of Bay Street’s past

Share

Like a ghost, the legacy of Royal Bank of Canada's first, failed American expansion still haunts the country's biggest banks.

To this day, it's the benchmark for what not to do, and the lessons learned quietly influenced Canadian Imperial Bank of Commerce's blockbuster deal last week.

In 2001, RBC acquired North Carolina-based Centura Banks Inc. for $3.5-billion. Six years later, and high off the U.S. credit bubble, the lender doubled down, buying Alabama National BanCorporation for $1.6-billion. The deals formed the bulk of RBC's U.S. retail banking arm.

By almost every measure, the endeavour was a mistake. The unit lost money for 10 straight quarters after the financial crisis broke out. RBC cut and run in 2011, selling the arm for $3.6-billion (U.S.) and writing off $1.3-billion (Canadian) in goodwill in the process.

Once free of the burden, RBC admitted its missteps. Former RBC chief executive officer John Cleghorn bought a second-tier bank in Centura, and his successor added to the position with an opportunistic bet. The loss wasn't big relative to RBC's total size, but the U.S. expedition forced the bank to expend far too much internal energy trying to make it work.

How far we've come. Since the start of 2015, Canadian banks have struck two seminal U.S. acquisitions – one of them by RBC – and this time the playbook looks much different.

In this new era, hefty multiples don't make executives flinch. Last year, RBC bought City National of Los Angeles for $5.4-billion (U.S.), or 2.6 times its book value, and last week, CIBC bought Chicago-based PrivateBancorp for $$3.8-billion, or 2.2 times its book value. In banking, anything above 2.0 times book has historically been deemed expensive.

The premiums were especially surprising after factoring in the target banks' returns on equity. At the time of purchase, City National's was just 9 per cent, while Private Bancorp's is 11.3 per cent. RBC's own ROE was 19 per cent in January, 2015, and CIBC's is currently 18 per cent.

Because City National's was so low, and because RBC paid such a rich price for it, Bay Street was particularly surprised. To calm everyone down, current CEO Dave McKay evoked the ghost of Centura. When RBC bought that bank, he said an interview, "We bought a franchise that had to be transformed and changed – it wasn't the 'Tier 1' franchise. Our biggest [lesson] from that failed venture was that you have to buy the highest-quality franchise and build on it."

With City National, the strategy was clear: target high-net-worth and ultrahigh-net-worth clients in major U.S. cities such as Los Angeles and New York. (City National is known as Hollywood's bank.) Now CIBC is doing something similar, zeroing in on the Chicago region as its base.

And unlike Centura, which RBC hoped to expand, both City National and PrivateBancorp already have growth baked in. Both banks have many loans that charge variable interest rates, so if the U.S. Federal Reserve ever raises rates again, their margins automatically go up.

There are alternative approaches. After Midwest-based Marshall & Ilsley got into trouble during the financial crisis, Bank of Montreal was able to swoop in and acquire it for roughly its book value. But it was a very complicated deal and M&I's loan book was written down considerably. BMO was effectively betting on a broad U.S. economic rebound.

Toronto-Dominion Bank's strategy, meanwhile, is more in line with RBC's and CIBC's because TD paid up for the quality assets it acquired south of the border: Banknorth and Commerce Bancorp. TD spent nearly $20-billion (Canadian) to get maximum scale, and, privately, some executives at the Big Six banks admit they're a bit jealous of TD for having the vision.

Yet there's still something to be learned from the so-called successful expansion. Even TD admits it didn't pan out as planned. For years, the U.S. retail arm's return on equity was under 10 per cent, a casualty of an ultracompetitive American market.

As much as that hurt, it was far better than what RBC had last go around. When markets crashed in 2007 and 2008, Royal Bank had to inject $$3-billion to $4-billion into its U.S. retail arm because it was so heavily exposed to the worst-hit sectors. TD skated through the crisis with a profitable U.S. division. The lesson: Quality endures.