The burning question on Bay Street: Did RBC overpay?

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Even if you buy the long-term acquisition strategy, and even if you believe in the acquired management team, you'd be crazy not to wonder if Royal Bank of Canada paid too much for City National Corp.

Bay Street quickly expressed shock and awe at the $5.4-billion (U.S.) price tag. In public, people were polite, suggesting that RBC paid a "full price" or that the price tag looked a "bit rich." In private, though, everyone asked the same thing: is RBC serious?

Broadly speaking, banks are typically purchased at prices that amount to between one and two times their book value. If the bank has a low return on equity, let's say 5 per cent, the buyer might pay a price equal to the target's book value; if a bank has a high return on equity, let's say 15 per cent, the buyer is likely to pay something closer to two times the target's book value.

RBC is buying City National for 2.6 times its tangible book value – a hefty multiple – yet City National's ROE is only 9 per cent. (RBC argues the more appropriate metric is City National's 12-per-cent return on tangible common equity, which strips out assets such as goodwill. However, an investment banker who covers financial institutions said few people use that metric.)

To be clear, RBC admits that it's paying a pretty penny. However, chief executive officer Dave McKay believes there's a boatload of growth potential that isn't baked into City National's current returns.

Chiefly, the bank has a hefty securities portfolio, and one-third of it is invested in short-term securities. (Banks with more deposits than loans, like City National, often invest the excess deposits to make some money.) Because a good chunk of City National's invested deposits will mature in the near future, RBC will be able to redeploy this cash in the merged entity. For instance, it can use the funds to offer loans to its existing U.S. wealth customers.

City National is also well-positioned for rising rates. Over 60 per cent of its deposits do not pay interest, and roughly 80 per cent of its loans are floating rate or have adjustable rates. When U.S. interest rates eventually rise, RBC will benefit in a big way.

Mr. McKay was also content with paying a hefty price for a quality business. When he started studying the best way to re-enter the U.S. market, he realized he had two options: Buy something on the cheap but then take on operational risk because you don't know if you can build on it; or pay a hefty price tag for a quality asset and then grow off a solid base.

When RBC bought Centura Bank, he said they took the first route, and paid for it dearly in the long run. "We bought a franchise that had to be transformed and changed – it wasn't the 'Tier 1' franchise," Mr. McKay said in an interview. "Our biggest [lesson] from that failed venture was that you have to buy the highest-quality franchise and build on it."

He also stressed that U.S. bank returns have long been lower than Canada's – it's just a nature of that market. RBC could hem and haw about paying a premium, or it could strike a deal that gives it an avenue for growth outside the heavily saturated Canadian market. Mr. McKay chose the latter.