Frustrated with a recent ratings downgrade and worried by the imminent possibility of another, Royal Bank of Canada is intent on proving that its capital markets arm poses no real threat to its future.
Late in 2010, rating agency Moody's Investors Service dinged RBC with a one-notch downgrade to double-A-1, citing concerns with the bank's growing capital markets business. Just over a year later, the agency came back and said RBC was at risk of a second two-notch hit as part of a new evaluation of global banks with big capital markets arms.
Facing another blow, RBC lashed out, arguing that its inclusion in a review of too-big-to-fail firms was "unwarranted," in part because its capital markets business represented less than 25 per cent of the bank's bottom line.
Building on this argument, RBC put together a special presentation for analysts and investors on Friday that focused solely on its capital markets business. The bank did not come out and say that the presentation was designed to prove Moody's wrong, but the potential downgrade was hinted at many times.
RBC also did its best to explain why it was safer than a U.S. bank like JPMorgan Chase, which recently demonstrated with a $2-billion (U.S.) loss just how quickly capital markets blunders can shock banks.
While its rivals have either tried to shrink their capital markets businesses, or are focusing on more-stable retail banking, RBC has actually built its wholesale banking division up in recent years. Since 2008, RBC Dominion Securities, the capital markets unit, has added about 1,000 people, a net number that accounts for employees who have left the firm. RBC has also spent a lot of money on advertising its capital markets arm, buying ads in magazines such as The Economist and promoting itself on business news networks such as CNBC south of the border.
During its presentation, RBC made one thing very clear: the bank is shifting its focus away from trading and toward more plain-vanilla corporate and investment banking. In doing so, corporate lending has become a hot business. Since 2009, RBC has increased the number of firms it lends to by 30 per cent to over 1,200, and over 70 per cent of these are investment grade companies.
Another key point: RBC's U.S. capital markets business now generates more revenue than Canada, bringing in 44 per cent of total revenues in the last four quarters, compared with Canada's 39 per cent. The U.S. division also employs many more 'front-office' capital markets employees: 1,705 to Canada's 1,085.
RBC also devoted a lot of time to risk management practices, another of Moody's concerns. In February, the rating agency noted that "rapidly changing risk positions expose these firms to unexpected losses that can overwhelm the resources of even the largest, most diversified groups." RBC noted that of the roughly 1,000 people added since 2008, the majority have been in the back office, where divisions such as risk management are housed.
The bank's trading inventory has also been cut from $151-billion (Canadian) in the third quarter of 2011 to $118-billion today. Much of the downsizing has come from fixed-income, a division whose balance sheet has shrunk by 15 per cent since last year. Plus, going back as far as 2009, RBC has slashed its legacy – or complex – assets in half by selling off or ring-fencing things like structured credit and auction rate securities.
Still, RBC remains exposed to the risky trading with which Moody's has taken issue. The bank hasn't ended its proprietary trading and Doug McGregor, co-chief executive officer of the capital markets arm, said that he believes this type of trading "is an important outlet for us to manage our liquidity and to profitably deploy surplus capital." However, he did note that proprietary trading accounts for less than 3 per cent of revenues.
As for the future, RBC made it clear that it does not plan to strike any major deals that would dramatically shake up its capital markets business. "We have no intention of making large acquisitions or expanding our footprint," Mr. McGregor said.