National Bank loves its capital markets arm, and thinks you should too

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In a world where banks are reluctant to show off their capital markets capabilities, National Bank Financial Inc. has adopted a contrarian view.

After the financial crisis wreaked havoc on wholesale banking, a slew of banks scaled back their capital markets arms and touted their plain vanilla banking operations. But National Bank chief executive officer Louis Vachon doesn't think he has any reason to play down his wholesale unit. Rather, his team should be talking it up. And that's precisely what they did on Wednesday at National Bank's investor day, its first in five years.

The knock on National Bank has long been that it is too Quebec-focused, and that its capital markets earnings, which comprise 38 per cent of its net income, are inherently volatile. For these reasons, the bank trades at a lower price-earnings multiple than its Big Six peers.

Mr. Vachon is now on a crusade of sorts to "demystify" the financial markets arm. While he is realistic about his efforts – "we cannot turn lead to gold" – he argues a major point: "All we're saying is [the unit] does not deserve the extensive discount" it receives relative to the retail operation.

Prior to 2004, he elaborates, there was never a discount for wholesale banking. And although it is understandable why the financial crisis altered that, much has changed since those tumultuous years. Any argument in favour of a discount is "passé," he said. "If you look forward now, we're back to more normal times and client-driven activities," like corporate lending.

Mr. Vachon isn't the only Big Six CEO who has had to defend his capital markets arm. In 2012 Royal Bank of Canada held an investor day of its own that focused on its wholesale banking after rating agency Moody's Investor Service downgraded the bank, in large part out of fears about the volatility of this unit's earnings.

RBC dubbed the downgrade "unwarranted" because its capital markets arm contributed less than a quarter of its earnings. Plus, the bank had already started to significantly scale back its trading inventory, which amounted to $151-billion in the third quarter of 2011.

At National Bank, derivatives expertise has been a major source of success. The desk's pre-tax earnings are expected to hit $335-million this year, up from $139-million in 2007. The bank sees more opportunities because it does a lot of work with exchange-traded funds, offering services such as market making and hedging. ETFs are only growing more popular with retail investors. The bank is also incredibly proud of Credigy, a collections agency it bought six years ago, which buys portfolios of bad loans from financial institutions. While the business sounds inherently risky, National Bank stresses that such risk is factored into the purchase prices for these portfolios, and they are often acquired at major discounts to the loan balances. Credigy isn't expected to be a power player, but it could account for 5 per cent of the bank's total earnings by 2017.

Because it is tough to earn fees in areas such as institutional equities, investment banking and mergers and acquisitions these days – nation-wide fees from these units are down 38 per cent this year from 2007 – NBF will lean heavily on its fixed-income and corporate lending divisions, where the bank has had big wins in the past few years.

Some rivals argue National Bank has an unfair advantage in these worlds, because it is the de facto underwriter for the province of Quebec, which has borrowed heavily since the crisis. But Mr. Vachon fought back against these claims, arguing that his fixed-income team has made big gains in corporate syndicates and in infrastructure fundraising.

There's a fundamental reason for that. Major global financial institutions, such as Deutsche Bank and Merrill Lynch, used to steal Canadian market share. But they've retreated since the crisis and clients suddenly woke up and realized National Bank's been calling them for 20 years.

Plus, Mr. Vachon joked, they realized that the bank, which is based in Montreal, has "a good hockey team back home."

(Tim Kiladze is a Globe and Mail Reporter.)

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