Earnings Call Transcript - BMO Q1 2020

Operator, Operator

Please standby, your meeting is about to begin. Please be advised that this conference call is being recorded. Good morning. And welcome to the BMO Financial Group's Q1 2020 Earnings Release and Conference Call for February 25, 2020. Your host for today is, Ms. Jill Homenuk, Head of Investor Relations. Ms. Homenuk, please go ahead.

Jill Homenuk, Head of Investor Relations

Thank you. Good morning and thanks for joining us today. Our agenda for today's investor presentation is as follows: We will begin the call with remarks from Darryl White, BMO's CEO; followed by presentations from Tom Flynn, the bank's Chief Financial Officer; and Pat Cronin, our Chief Risk Officer. We have with us today Cam Fowler from Canadian P&C; and Dave Casper from U.S. P&C.; Dan Barclay is here for BMO Capital Markets; and Joanna Rotenberg is here for BMO Wealth Management. After their presentations, we will have a question-and-answer period, where we will take questions from prequalified analysts. To give everyone an opportunity to participate, please keep it to one question. Darryl will then close the call with concluding remarks. On behalf of those speaking today, I note that forward-looking statements may be made during this call. Actual results could differ materially from forecasts, projections or conclusions in these statements. I would also remind listeners that the bank uses non-GAAP financial measures to arrive at adjusted results to assess and measure performance by business and the overall bank. Management assesses performance on a reported and adjusted basis and considers both to be useful in assessing underlying business performance. Darryl and Tom will be referring to adjusted results in their remarks, unless otherwise noted as reported. Additional information on adjusting items, the bank's reported results and factors and assumptions related to forward-looking information can be found in our 2019 Annual Report and our first quarter 2020 report to shareholders. With that said, I'll hand things over to Darryl.

Darryl White, CEO

Thank you, Jill and good morning, everyone. Today, we reported a very strong and balanced Q1 performance with earnings of $1.6 billion up 5%, including revenue up 8% and pre-provision pre-tax earnings up 16%. All of our businesses contributed, delivering good performance consistent with business potential and with clear momentum in key areas of competitive strength. In Q4, we expressed to you confidence going into the new year with optimism around stabilizing economic environment, overall client sentiment and, of course, our own business plan. Today's report supports that view. For the quarter, we delivered operating leverage of 4.6% with every business above 2%. Efficiency improved significantly by 270 basis points year-over-year with a strong total bank revenue performance and disciplined expense management. And we remain committed to an expense growth rate of 2% or better for the year. The strength of our operating performance allowed us to earn through elevated provisions. Overall, portfolio credit quality remains good with some pressure in two areas, and we expect provisions to come down from this quarter's level. Pat will discuss provisions in more detail in his remarks. Capital remained strong at 11.4% even after absorbing regulatory changes in the quarter. Our U.S. segment continues to deliver against healthy expectations. U.S. PPPT was up 10% with a particularly good contribution from capital markets. This quarter, every one of our businesses contributed to achieving our objective of consistent long-term financial performance executing against clear customer-driven competitively differentiated strategies. Starting with Canadian P&C.; We had another strong quarter with net income growth of 8% and PPPT growth of 10%. Robust loan and deposit growth contributed to overall strong revenue growth of 7%, resulting in the highest operating leverage in Canadian P&C in the past 12 quarters at 3.6%. We're seeing steady market share gains across almost every product category including personal deposits, lending and cards as well as commercial deposits and lending, all consistent with the strategy we outlined at Investor Day. In personal, we were extremely proud to receive the top overall score in J.D. Power's 2020 Canadian Retail Banking Advice Study marking a major leap forward from our third-place ranking last year. BMO placed first in five of seven categories in the study, which measures customer satisfaction with the advice and guidance they receive from five major Canadian banks. And at the same time, the BMO Performance Plan was rated the best checking account with a big bank in Canada by MoneySense magazine. On the digital innovation side, this quarter we introduced BMO Insights, a personalized automated solution that uses artificial intelligence to provide actionable insights to help customers manage their day-to-day finances and cash flow. Canadian commercial also continues to be a core element of our success as we drive above-market performance in line with our risk appetite and with no change in our disciplined approach to pricing. Our success is driven by our expertise, our unparalleled industry knowledge and our commitment to going above and beyond for our customers. And increasingly, that's with the support of digital innovation as well. For example, BMO Business Xpress, our industry-leading small business lending platform, which allows customers to be approved for a loan in just minutes, is on track to surpass $1 billion in new authorizations next month. Turning to U.S. P&C.; We had another good quarter absorbing the full impact of recent rate decreases while still driving year-over-year constant currency revenue growth of 3% and PPPT growth of 5%. Disciplined expense management helped deliver positive operating leverage of 2.1% and a new low efficiency ratio of 55.2%. NIM remained relatively stable quarter-over-quarter, with the benefit of deposits growing faster than loans and our expectations are for continued stability through the year. Our U.S. commercial business delivered double-digit year-over-year loan and deposit growth, with some expected quarter-over-quarter moderation in loan growth. This quarter, we announced the opening of our first commercial banking office in Los Angeles, building on an already strong presence in Southern California. As many companies headquartered in California have significant Canadian operations, it's further proof of our commitment to provide our North American customers with unparalleled commercial expertise and value. We look forward to talking to you about this along with more on our strategy to continue to build our leading North American commercial presence at our April 6 investor event. In U.S. Personal and Business Banking, our deposit momentum continues, with digitally acquired deposits growing nearly 65% quarter-over-quarter. Digital accounted for just over 20% of total retail deposit growth this quarter in the U.S., with 98% of that coming from markets outside of Illinois and Wisconsin. Turning to Wealth Management. With net income growth of 21%, PPPT growth of 24% and operating leverage of 5.9%, Wealth Management delivered a strong balanced performance driven by higher client assets, continued diversification through double-digit loan and deposit growth and the benefit of disciplined expense management. The business continues to strengthen and streamline with targeted investments in key competitive growth areas. This quarter, we launched a suite of seven ESG ETFs that add to our leadership position, and we led the industry on ETF net inflows. We also recently opened new private wealth offices in both Dallas and Atlanta, joining forces with our commercial bankers there. This is a great example of how we're increasing our wealth penetration with our Commercial and Business Banking customers, a key growth segment for BMO. Capital Markets had a very strong quarter with positive contributions across businesses and geographies. Net income growth was 38%, with PPPT up 50%. It was a good start to the year, with potential for revenue opportunities greater than we would have expected a quarter ago. Investments we've made in Capital Markets are proving their return, as the business is now more consistently performing in line with earnings potential. Our U.S. Capital Markets business, for example, delivered net income above US$100 million and pipelines across the franchise remained good. In January, we announced an agreement to acquire Clearpool, a cloud-based electronic trading platform with customizable algorithmic strategies. This acquisition emphasizes our commitment to clients, as we provide leading-edge innovative trading technology to our global client base and we expand our business and areas of opportunity and strength. Another area of opportunity for us is sustainable finance. This quarter, BMO Capital Markets led the first Canadian sustainability-linked credit facility for a major corporate client. Following on the footsteps of our inaugural sustainability bond, these initiatives are cementing a leadership role for us within the market, one that will help drive long-term sustainable financial performance. So looking ahead, we feel confident for 2020. We have a strong and diversified business, well-executed strategies and great momentum. Our performance this quarter reflects our disciplined approach and our commitment to our strategy and we're confident in our ability to build on our performance through the year. Our success will be determined by the consistency of strategy and performance, as well as consistency of purpose. Our purpose to boldly grow the good in business and life unites our employees, builds trust and loyalty with our customers and sets a clear path for our future. Today we're very proud to be named by the Ethisphere Institute as one of the world's most ethical companies for 2020, a recognition that we've now received three years in a row. And for the second consecutive year, BMO Harris Bank was recently recognized by Forbes Magazine in its Annual List of America's Best Employers for Diversity, a recognition that highlights our commitment to encouraging diversity and supporting all our employees. Diversity in all its facets is a cornerstone to our success. Supporting inclusive communities and workplaces is a critical component of that. This quarter, we announced a research partnership with the Canadian Center for Addiction and Mental Health culminating in a corporate playbook to advance mental health awareness in workplaces. We encourage every corporate leader to take accountability by adopting the playbook, as we firmly believe business performance success is only possible when directly tied to a strong commitment to workplace mental health. Supporting our customers, our communities and our employees is how BMO will continue to drive long-term sustainable value and strong relative financial performance. And so, with that, I'll turn it over to Tom to talk about the first quarter financial results.

Tom Flynn, CFO

Okay. Thank you, Darryl, and good morning, everyone. My comments this morning will start on slide eight. Q1 reported EPS was $2.37 and net income was $1.6 billion. Adjusted EPS was $2.41, up 4%, and adjusted net income of $1.6 billion was up 5%. As Darryl said, results in the quarter reflect good performance across our businesses with pre-provision pre-tax earnings growth of 16%, operating leverage of 4.6% with each operating group above 2%. Good revenue growth and operating leverage helped us comfortably earn through higher credit losses in the quarter. Adjusting items this quarter are similar to past quarters and are shown on slide 25. Turning now to revenue, net revenue of $6 billion was up 8% from last year, reflecting strong performance in BMO Capital Markets, Canadian P&C and BMO Wealth Management. Expenses increased 3% largely reflecting higher employee-related expenses given strong revenues, and higher technology costs partially offset by the benefits from productivity initiatives. We continue to make good progress on efficiency with total bank efficiency at 60.3% in the quarter. As a reminder, expenses in the first quarter of each year include costs related to stock-based compensation for employees who are eligible to retire. This expense was $90 million in Q1. Excluding these costs, the efficiency ratio would have been 58.8% in the quarter. We are on track to deliver the expense savings from our Q4 restructuring charge in line with prior guidance. As a reminder, the expected annualized run rate savings in Q4 of this year are approximately $300 million with full year benefits in the income statement of approximately $200 million. These savings will contribute to achieving our 2% or better expense growth target for the year. Moving now to slide 9 for capital, the common equity Tier 1 ratio was 11.4%, unchanged from last year or last quarter rather, with retained earnings growth offset by the impact of regulatory changes and the adoption of IFRS 16, which together had a 16 basis point impact on the ratio and higher risk-weighted assets. We expect the previously announced acquisition of Clearpool Group to close in the second quarter with a capital ratio impact of a little less than 10 basis points. Moving to our operating groups and starting on slide 10, Canadian P&C had another strong quarter in Q1. Net income was $700 million, up 8% and pre-provision pre-tax earnings growth was 10%. Revenue was strong at 7% driven by higher balances, higher margins and non-interest revenue. Total loans were up 7% with commercial loans up 15%. Mortgage growth through proprietary channels including amortizing HELOCs was 6%. Deposit growth continued to be very good at 14%. Expenses increased 3%, primarily due to higher technology and pension costs. Operating leverage was strong at 3.6% and efficiency improved to 47.3%. Moving to U.S. P&C on slide 11 and my comments here speak to the U.S. dollar performance. Net income of $275 million was down from strong performance a year ago due to higher credit provisions partially offset by higher revenue. As a reminder, credit provisions benefited from a recovery in Q1 of last year. Pre-provision pre-tax earnings growth was good at 5%. Revenue was up 3% driven by loan and deposit growth and higher fee income, partially offset by a lower net interest margin. Average loan growth was 12% with commercial up 13 and personal up 9%. Deposit growth continued to be strong up 11% from last year. The net interest margin was down just one basis point from last quarter. The change in NIM was better than anticipated, reflecting less deposit spread, price pressure and strong sequential deposit growth. With expense growth of under 1%, operating leverage was 2.1% in the quarter and efficiency 55.2%. Provisions for credit losses were up from last year at $113 million. Pat will provide color on this in his remarks. Turning to slide 12, BMO Capital Markets had a good quarter with net income of $362 million, up 38%. The U.S. business continued to have strong performance with net income of US$110 million, up 53% and representing 40% of Capital Markets earnings in the quarter. Revenue was up 20% with strong growth across both global markets and investment in corporate banking. Operating leverage was strong at 13%. Over the last three quarters, Capital Markets net income has averaged $320 million, which we feel is reflective of the earnings potential of the business. Moving to slide 13, Wealth Management had a good quarter with net income of $300 million, up 21%. Traditional wealth net income of $218 million was up 19%, reflecting higher revenue and positive operating leverage. Loan and deposit growth continues to be strong at 14% and 12% respectively. Insurance net income was $82 million up 26% primarily due to positive market movements in the quarter. The higher insurance income in the quarter was offset by costs from stock-based compensation expense in Q1, and so in effect the underlying earnings were at the $300 million level. Expenses were up 2%, reflecting higher revenue-based costs, and operating leverage was strong at almost 6%. Turning now to slide 14 for corporate services, the net loss was $106 million compared to a net loss of $76 million a year ago. Results decreased primarily due to lower treasury-related revenue and higher expenses. To conclude, the strong first quarter performance demonstrates continued momentum in our business, consistent delivery against our strategic priorities, and the benefits of our diversified business mix. And with that, I'll hand it over to Pat.

Pat Cronin, Chief Risk Officer

Thank you, Tom and good morning, everyone. Starting on Slide 16. The total provision for credit losses this quarter was $349 million or 31 basis points. While our impaired provisions are elevated this quarter, the overall credit quality of our lending books remains sound and we do not see any indications of broad-based credit weakness. Consequently, based on current business conditions, we expect our loss rate on impaired loans to revert to more normal levels in the coming quarters. The increase in impaired provisions this quarter was primarily due to higher losses in U.S. Commercial, largely due to normal quarterly loss variability as well as from specific weakness in transportation finance. In addition, our corporate lending portfolio has experienced higher losses this quarter, concentrated entirely with oil and gas accounts. Apart from oil and gas lending and transportation finance, our other lending portfolios exhibited stable credit metrics and low losses in the quarter. Turning to the specific credit performance in the businesses. Canadian consumer impaired loan provisions decreased $7 million quarter-over-quarter to $103 million, which at approximately 26 basis points is lower both compared to last quarter as well as last year. Also, as shown in the supplementary financial information package, Canadian consumer delinquencies decreased both compared to last quarter and to Q1 of 2019. Canadian commercial PCL on impaired loans increased to $35 million from $24 million last quarter. There were no specific industry trends or themes observed. And at approximately 16 basis points, this quarter's PCL rate reflects solid credit performance in Canadian commercial consistent with the long-term average for this business. U.S. consumer PCL on impaired loans was $16 million, down slightly from the prior quarter. U.S. commercial PCL increased to $116 million due to one larger loss and elevated provisions in the transportation finance sector, reflecting continued weak conditions in the U.S. trucking market. This weakness in transportation finance and the one larger loss I referred to accounted for approximately 50% of the total PCL in U.S. commercial this quarter. The remainder was a function of the normal variability we see from time to time in commercial portfolios with no discernible theme. Capital Markets PCL on impaired loans was $53 million. Consistent with last quarter, the provisions were entirely in the oil and gas sector and predominantly related to U.S. natural gas accounts, where very low commodity prices for natural gas continue to pressure some borrowers in this sector. Switching briefly to Slide 17. Our U.S. exploration and development exposure is $4.5 billion, a decline of approximately 4% from the prior quarter. Breaking this sector down further, we estimate gas-weighted gross loans and acceptances represent less than 1% of total business in government lending when measured on the basis of revenue. Turning back to Slide 16. The provision for credit losses on performing loans was $25 million, mainly reflecting modest credit migration and balanced growth. On Slide 18. Formations were $831 million, up modestly from $799 million in the last quarter with the increase fully attributable to business and government formations. The ratio of gross impaired loans to total loans increased four basis points to 62 basis points, driven by the higher formations and lower write-offs relative to recent quarters. In summary, overall credit quality remains strong, despite the higher provisions in our U.S. commercial portfolio and our natural gas loan book. And although there will be some continued pressure in oil and gas and transportation finance, I expect the impaired provision to nonetheless decline over the next few quarters with loss rates averaging in the mid-20 basis points range. I will now turn the call over to the operator for the question-and-answer portion of today's presentation.

Operator, Operator

Thank you. We will now take questions from the telephone lines. The first question is from Meny Grauman with Cormark Securities. Please go ahead.

Meny Grauman, Analyst

Hi, good morning. Pat I just wanted to follow up on the credit side of things. You gave a good detail but I'm just wondering more big picture, what gives you confidence that what you're seeing is not the beginning of something more significant? Can you talk about transportation in particular? And then just overall key indicators that give you confidence in that better outlook for the rest of the year.

Pat Cronin, Chief Risk Officer

Sure. Thanks for the question, Meny. Yes, and I would definitely say that this quarter in our view is an anomaly. And as I said in my comments, we expect the PCL to normalize starting in Q2 and then running for the balance of the year. And the reason that we believe that is when we look across the various portfolios, first of all starting with the consumer books in particular, both Canada and the U.S. consumer books continue to be very solid. I think when you look at the PCL numbers and the delinquency rates, there's no reason for us to conclude that those low losses won't continue for the balance of the year. Canadian commercial at 16 basis points again, a very solid quarter. We see no sector weakness or underlying decay in the credit metrics. So, we expect Canadian commercial to stay within that range over the balance of the year. When I look at Capital Markets, the story really is just U.S. natural gas. Outside of natural gas, we had virtually no PCL in any other sector in capital markets this quarter. And then with respect to natural gas, we do expect that to moderate over the course of the year. When we look at our portfolios from the bottom-up in both Houston and in Calgary, we see the PCL rates coming down in Q2, Q3 and Q4. They won't be zero of course. But I think if you look at the two goalposts of zero and where we were this quarter, somewhere in the middle of that range is probably a pretty good forecast for the balance of the year. So that really just leaves U.S. commercial. And of course, TF, as I mentioned, is a spot of weakness. But keep in mind the numbers are relatively small there in terms of total losses. And that's really a cyclical issue, very specific to that sector. I would expect the loss to be somewhat similar next quarter, and then declining linearly to the end of the year. And so apart from that, we really had one lumpy loss as I mentioned. And that plus TF was really 50% of the PCL in U.S. commercial. As we look at all the other sectors, we don't see any reason to think that the rest of the portfolio won't perform fairly consistent with what you saw through most of 2019. And so, and then when I look at the credit metrics, in particular, for U.S. commercial, I look at the weighted average probability of default in that sector, it actually went down slightly from Q4, and is virtually flat relative to Q1 of last year. So, that tells me there's no broad-based deterioration in the portfolio, outside of that weakness in TF. And that same trend for the probability of default is similar for the wholesale portfolio in aggregate. And so, when I look across the books, when I look at the sectors, when I look at the strength of the consumer portfolio, the strength of Canadian commercial, the strength of Capital Markets outside of oil and gas, to me that all adds up to a moderation in the loss rates, again into that range of the mid-20 basis point range that I talked about in my comments.

Meny Grauman, Analyst

And just, as a follow-up. We've heard from other banks that talked about coronavirus. I'm just saying, it's too early to tell. But just, to clarify, when you talk about the outlook, you're assuming no issues from that emerging risk, I would say.

Pat Cronin, Chief Risk Officer

I would say, first and foremost, that it's probably too early to tell. Our primary concern is the health and safety of our employees in Asia and other affected regions. We are focused on business continuity to ensure stability in all of our regions in case the situation worsens. We're closely monitoring the tail risks within our mark-to-market books, and we aren't currently seeing any short-term impacts from COVID-19. We're managing those books carefully. In terms of credit portfolios, the effects may take longer to materialize, depending on the severity and duration of the situation. When we assess the first-order effects, we don't observe concentration in sectors that would be severely impacted. For instance, we have no exposure to cruise ships, which gives us some comfort that the initial impacts are likely to be relatively minor. However, second-order effects, such as supply chain disruptions and slowing economic conditions, will take longer to unfold, and it’s too early to predict those outcomes. We'll likely begin to see some effects as we progress through the year, which might be reflected in the performing provision. In the short term, there may be changes in macroeconomic forecasts depending on our economics group’s assessments, but it’s probably too early to draw long-term conclusions.

Meny Grauman, Analyst

Thank you.

Operator, Operator

Thank you. The next question is from Steve Theriault with Eight Capital. Please go ahead.

Steve Theriault, Analyst

Thanks very much. Just sticking with Pat, for a second.

Darryl White, CEO

Hey Steve, we lost you.

Steve Theriault, Analyst

Sorry, can you hear me okay there?

Darryl White, CEO

Yeah. We got you now.

Steve Theriault, Analyst

Apologies, so sticking with Pat, you did not put too fine a point on it, but you mentioned mid-20s a couple of times. So that is intended to be sort of your thoughts on the full year PCL rate or the remainder of your PCL rate?

Pat Cronin, Chief Risk Officer

No, to be specific, that's for the remainder of the year. And obviously there can be quarter-to-quarter variability as you saw, this quarter that's pretty normal. But on average for the balance of the year we would expect to see something around that range for the next three quarters.

Steve Theriault, Analyst

Okay. It seems that what we're hearing indicates there was a specific loss. Can you clarify whether it was related to the construction item or the services industry item mentioned in the provision schedule? Additionally, could you provide more details on this? Was it related to fraud, or was it something else?

Pat Cronin, Chief Risk Officer

No, it was in the construction sector and not related to fraud. It involved a client we have been working with for many decades in a unique part of the construction industry. This situation is not reflective of the broader sector. The client encountered specific difficulties, and while we tried to assist them, it unfortunately resulted in a provision for credit losses in the quarter. This is indicated by a noticeable increase in overdue loans in that sector, but it's primarily related to this one client. We have since ended our exposure there, so we do not expect any additional provision for credit losses from this issue and anticipate that the overdue loans will decrease in the next quarter.

Steve Theriault, Analyst

Okay. Thanks. And then, Tom if I could, you talked through the margin in the U.S. And obviously good news that the margin only being down one basis point. But you talked about strong deposit growth. You talked about competition. The deposit growth actually looks a little weaker than the last few quarters. So was it that deposit growth was coming off? Or was it more the mix of the deposit growth? Maybe just some color there.

Tom Flynn, CFO

Yeah, sure. So I'd say we are very happy with the margin in our U.S. P&C business. We had guided on our last call to a decline in the upper single digits and in fact we came in at down one. And the big drivers there were a better pricing environment in the market. And when I say better, better than what we had seen off of the earlier fed cut. And then as well we had our loans growing at a higher rate of deposits. So on the margin, the relative rate of growth is important and deposit growth exceeded loan growth and that helped the margin. And those were the big two drivers. And looking forward for the balance of the year, we do expect to be in a better place than we had thought. And so give or take we think the better margin holds through the balance of the year.

Steve Theriault, Analyst

Okay. That’s helpful. Thank you.

Operator, Operator

Thank you. The next question is from Scott Chan with Canaccord Genuity. Please go ahead.

Scott Chan, Analyst

Thanks very much. Just sticking to the U.S. side. I see loan growth was pretty strong up 12% in total. Are you still sticking to your high single-digit loan growth target in fiscal 2020? And if you are maybe talk about why we think there's going to be deceleration throughout the year? Thanks.

Dave Casper, U.S. P&C Executive

So this is Dave. I still believe we will maintain our high single-digit growth target. I mentioned this during the last quarter, and I also indicated that it would likely surpass that target since we've previously exceeded market growth while expanding into new areas. I expect this trend to continue without any changes on my part. Although we experienced a slight dip in the first quarter, we are still seeing growth, just not as robust. However, I anticipate that this will improve as the year progresses.

Scott Chan, Analyst

Okay. Thank you.

Operator, Operator

Thank you. The next question is from Ebrahim Poonawala with Bank of America. Please go ahead.

Ebrahim Poonawala, Analyst

Hi, good morning guys. First just wanted to follow-up, Pat very quickly on the oil and gas portfolio, I'm sorry if I missed it. Have you disclosed how much of the book is nat gas related versus oil?

Pat Cronin, Chief Risk Officer

We estimate that less than 1% of our total business in government loans comes from U.S. natural gas, and you can assess this based on revenue, which is a reliable estimate.

Ebrahim Poonawala, Analyst

Got it. And just in terms of when you talk to a lot of banks exposed to the shale sector in Texas energy space, it feels like we're going to see maybe 12 to 24 months of just cleanup going on as kind of the capital sources for some of these companies have dried up. Like is your comfort around that book a function of like you've done a deep dive and you don't expect any one-off lumpiness over the next few quarters? Like what's driving that? Because when I hear some of your peers in the U.S. they kind of talk about the potential for more volatility at least over the next year as some of this flow through the pipe?

Pat Cronin, Chief Risk Officer

Yeah. So we're certainly not forecasting when we think about loss rates or prospects for the sector increases in natural gas prices. There's likely to be some upward migration on that price, but fairly modest over the course of the next couple of years. So I think we're consistent there. Our view on losses coming out of the U.S. natural gas book in the next couple of quarters is, as I said, based on a bottoms-up analysis of our book. And so we look at not just the cash flow of our various clients, but their ability to liquidate assets in the event of a bankruptcy process and look at our asset coverage relative to loan value. And so it's a fairly detailed analysis. Obviously there can be surprises in there, but the number that I gave you that range that I gave you earlier is our best estimate at this time based on a reasonably detailed bottoms-up analysis of that U.S. book.

Ebrahim Poonawala, Analyst

Understood. And I guess just a separate question, Tom around I think you said Capital Markets last four quarters, the average being $320 million and that's kind of what you view as the earnings power for that business. Does that imply that you don't expect quarters like what we saw last year like a sub-$300 million quarter? Was that the message in there? Or I just want to make sure I understand that correctly.

Tom Flynn, CFO

Yeah. I'll say something briefly and then I'll hand it over to Dan Barclay. So we do see the $320 million as just being reflective of the earnings potential of the business. We've invested in the business over time and yeah we've had very strong performance in the U.S. And so we're comfortable at that level. But I'll hand it over to Dan to give a little color to that.

Dan Barclay, Capital Markets Executive

Sure. Thanks Tom. And I appreciate the question. As we look forward, I think Tom has highlighted that the key piece. As we have made the investments across the U.S. as well as adjust on some of our cost structure, what you see is that the move up into the next level of earning potential. As Tom mentioned, the last three quarters average works out to be about $320 million. We, obviously, had a very strong quarter this quarter above that at $362 million. And so, that's what we see going forward, strength in most of the businesses in the U.S. both on the market side and the banking side and the corporate lending side all client-driven. When we look at the pipelines and what we've seen to date, that continued on to Q2. And so, yes I think we're confident that that's where we can see the business going forward.

Ebrahim Poonawala, Analyst

Got it. And just since we have you Dan, is the U.S. business where you want it to be? Like just if you can maybe briefly talk about any investment spend or market share opportunity that you're looking at actively given some of the retrenchment of maybe the European players. Just how do you think about the U.S. business, where it stands today?

Dan Barclay, Capital Markets Executive

Yes. I think consistent with where we've been at the quarter and at this quarter, last quarter and at Investor Day last year, we continue to push forward to drive and double our market share in the U.S. We've made all the substantial investments and so now it's into the scaling process around that. We do have multiple investments in most of our product lines, both people and banking. You saw the acquisition we made in Clearpool this quarter. You'll remember back the KGS acquisition we made 18 months ago. All of those are investments that are continuing to grow and will bear fruit over time. And so, I do have good confidence in our U.S. business and the growth that we see there.

Ebrahim Poonawala, Analyst

Got it. Thank you for taking the questions.

Operator, Operator

Thank you. The next question is from Gabriel Dechaine with National Bank Financial. Please go ahead.

Gabriel Dechaine, Analyst

Good morning. Thanks Pat for your thoroughness in the explanation of this quarter's credit trend. But one of the frequent pushbacks I get from investors on the bank's growth in the past few years in the commercial book is 15% type growth. It's good on one hand, but the worry is about the credit quality down the road. What kind of confidence do you have or that what we see this quarter described as idiosyncratic losses or one-offs or whatever won't start popping up a year or so from now following this strong period of the commercial growth we've had in the bank both in Canada and the U.S.? And if Dave or Cam want to pipe in that's great too.

Pat Cronin, Chief Risk Officer

Thank you for the question. I'll begin, and then Dave and Cam can add their insights. I appreciate your concern. The growth rates in 2019 were notably high. I want to clarify that the provision for credit losses you're seeing this quarter in U.S. commercial largely did not originate from any accounts added in 2019. Most of it stems from older vintages, including a significant loss that I mentioned, which dates back several decades. Therefore, we don’t see a correlation. Additionally, we closely monitor the weighted average probability of default for new additions to the U.S. commercial loan book and compare it to the average for the overall portfolio. Since Q1 of last year, new additions have consistently exhibited better credit quality than the average portfolio. Based on this information, we do not expect to see provisions for credit losses from recent vintages, and we haven't seen that this quarter. We wouldn't anticipate it over the next 12 to 24 months.

Dave Casper, U.S. P&C Executive

So, let me just add to that. This is Dave. It's a great question regarding the U.S. and it's a natural inquiry considering the growth we've experienced. I want to emphasize a couple of points. First, the growth has been quite intentional over the past 10 years and has mainly occurred in areas where we were previously absent, where we understand the business, and most of our operations are backed by assets. I feel very confident about the growth and would never apologize for it. This quarter, however, was particularly disappointing for PCL. Our team excels in two key areas: they take care of their clients and they win new business, and they take pride in that. They dislike losing money, and they are certainly feeling the pressure this quarter, as are we all, especially after losing a 40-year customer we've supported for so long. That’s a significant loss. Looking ahead to the next quarter and the remainder of the year, I’m optimistic about where Pat has projected his PCL. I believe we will perform well, as we typically do, and we will see how it unfolds. It's fair to be skeptical, but we will aim to prove you wrong, just as we have in the past. It’s genuinely a solid business and continues to be so. I'll stop there, and Cam may want to share more about the commercial side.

Cam Fowler, Canadian P&C Executive

It's Cam speaking. On the Canadian commercial side, I want to remind you that our strategy focuses on creating capacity and diversification. One of the main factors driving our strong growth in Canada is the increased capacity we have, whether through the hires we've made, especially in the Greater Toronto Area, or through the capacity we've built with our digital tools. As Darryl mentioned earlier, we have now processed $1 billion through our automated lending platform, which allows us to deploy more capacity to our current customers and prospects. There are two reasons for our confidence. First, we're experiencing strength across seven sectors in five regions, which is quite broad and diverse for our country. Second, as Pat noted regarding spread and the weighted average probability of default, the new business we’re acquiring is performing better than our existing portfolio. For these reasons, we are feeling confident.

Pat Cronin, Chief Risk Officer

And Gabriel, it's Pat just one more time. We'll hit this issue head on as well in the investor event that we're holding that I'm sure you're aware of coming up. It will be a combination event between the commercial segments and risk to walk you through exactly why we've been comfortable with growth rates and why the risk profile of the portfolio remains consistent with our appetite over the course of the last few years.

Gabriel Dechaine, Analyst

I look forward to that. Many people are curious about how, while most banks are struggling to grow, you are managing to grow and simultaneously enhance credit quality. Thank you.

Operator, Operator

Thank you. The next question is from Sumit Malhotra with Scotiabank. Please go ahead.

Sumit Malhotra, Analyst

Thanks and good morning. First question is for Tom. I think, it's for Tom. Just to go back to your transportation finance purchase, it was about five years ago now. Not to put you on the spot. I know when you bought this portfolio it was about $12 billion. I don't think it's all housed in the transportation section of your loan book breakout. Do you know approximately where this portfolio size is now a number of years after that purchase?

Tom Flynn, CFO

Yes. The portfolio now is about $12.8 billion. And I haven't looked at this number for a while, but I think at the time of purchase, it was closer to $10 billion than to $12 billion. So it's grown at a gradual rate over time and we didn't expect it to be a fast grower. It's a mature business and a good one from an ROE perspective. And so, it's performed largely in line with expectations. We're happy with business. And I could go on here, but I'm looking at Dave and so maybe I'll let him add a few comments.

Dave Casper, U.S. P&C Executive

Yes, I believe those numbers are correct. Most of the business is within our commercial operations in the U.S., with around 10% in Canada. As we've noted before, this team is the most experienced in the industry, which is what we appreciate the most. They have navigated through various cycles and have a strong ability to predict them. Currently, although this cycle seems to be shorter, we’ve noticed some competitors enter when times are good only to exit quickly. Recently, a few have left, which ultimately benefits us. We have the best team to manage through these cycles, and I am very pleased with our situation.

Sumit Malhotra, Analyst

And this is more of an industry question. It's probably for you Dave. I mean as you said you're not going to apologize for the loan growth. And sequentially it does seem to be a bit normal not to put too much emphasis on 3 months. We also have seen a decelerating trend in the Fed data when it comes to C&I loan growth in the U.S.? In your opinion is that a reflection of the industry to margin trends? Or has there been perhaps some deceleration in commercial activity in aggregate across the U.S.?

Dave Casper, U.S. P&C Executive

Yes. I believe there has been a slight decline and some concerns regarding uncertainty in various areas over the last fiscal quarter. Putting the coronavirus aside, I've noticed improvements recently. There appears to be greater stability in the U.S. regarding several issues. Therefore, I don't anticipate this trend to persist, and I expect the economy to strengthen, leading to better performance on our end as well. While the Fed data is important to monitor, I foresee an overall improvement. That's my personal opinion.

Sumit Malhotra, Analyst

Yes, that's good. I was going to switch over to Cam Fowler, if that's alright. With the strong momentum in your business, you might not receive enough questions. One factor contributing to your revenue outperformance in the past couple of quarters has been the favorable trend in net interest margin compared to some of your peers. I could discuss some of the factors driving this, such as deposit mix, but I would prefer to hear from you. From a business perspective, is there something about how your team has approached growth across your product range that is contributing to the significant outperformance in margin this quarter?

Cam Fowler, Canadian P&C Executive

Thanks for the question. Thanks for the chance to chat for a little while as well. I think you've probably answered it for me. In Investor Day in 2018, we talked really specifically about the Canadian P&C business and we talked about outsized growth in deposits in payments and in commercial. And you can see roughly two years on, we are taking market share in all of those categories. And so to me that mix and the quality of mix point is the single biggest driver. It is really important that deposits are moving like that. It's really important that payments are moving like that. So that to me is the biggest driver.

Sumit Malhotra, Analyst

Last one for you. Have you noticed any changes in the competitive landscape for commercial loans? It seems that there's a variation in perspective among the individual banks regarding their projections for commercial loan growth in 2020.

Cam Fowler, Canadian P&C Executive

I would say that it's somewhat different depending on the region and sector. Regarding our diversified growth, it does seem to vary everywhere. Overall, we anticipate some moderation in the latter half of the year, particularly in Q3 and Q4, but that's a definite comment. Relatively speaking, I expect us to maintain a strong position.

Operator, Operator

Thank you. The next question is from Robert Sedran with CIBC Capital Markets. Please go ahead.

Robert Sedran, Analyst

Good morning. Just sticking with the Canadian business, I wanted to ask about the payments in the credit card side. And I'm not sure if it's for Cam or for Tom or perhaps for both. But you do see good outstanding growth in the credit card business, but I see the card fee line is down in the supplemental at the all bank level. So, I guess, for Cam which cards or which category of cards are the ones that are doing best for you, that are performing best for you? And then perhaps some explanation as to why that card fee line is down please?

Cam Fowler, Canadian P&C Executive

Sure. The card fee line will recover. There are a couple of factors affecting this quarter, including some pressure from interchange and the recent Quebec legislation. However, I anticipate improvements in the second half of the year. Overall, the card performance is quite balanced, with the entire portfolio progressing as we predicted, thanks to our investments in marketing and data. I'm particularly pleased with the growth from the small business suite we launched over a year ago, which includes four or five new cards and features. Although it's a smaller segment, it's the fastest-growing part of our portfolio. Overall, I expect stronger performance across the entire portfolio and an uptick in the latter half of the year.

Robert Sedran, Analyst

I was under the impression that we were going to see some pressure on the card fee line in the second half of the year, but I guess for you you're saying that's not the case.

Cam Fowler, Canadian P&C Executive

I think that there will be different forms of pressure. I just think that we have momentum that will see us through it.

Mario Mendonca, Analyst

Good morning. Pat, can you clarify whether you mentioned the Canadian commercial PCLs ratio is around 16 basis points?

Pat Cronin, Chief Risk Officer

That's correct.

Mario Mendonca, Analyst

I believe you mentioned that this aligns with your long-term average, but I'm curious because I see a different number from the industry perspective. Could you clarify what time period you are referencing? Have you considered the periods when commercial real estate faced challenges?

Pat Cronin, Chief Risk Officer

I’m not referencing the financial crisis since our current situation is quite different. Specifically, our commercial real estate mix at BMO has changed significantly. If we compare it to various periods, it appears to be stable, much like what we experienced in 2016, 2017, and early 2018. As you know, we entered a strong credit phase towards late 2018 and throughout 2019, which provided excellent credit conditions for commercial portfolios in both Canada and the U.S. We anticipated that our numbers would likely rise from those very favorable levels we experienced during that time. However, reaching a level of 16 basis points seems appropriate for a well-diversified commercial portfolio of our size.

Mario Mendonca, Analyst

And so the long-term average that I would come up, but I imagine others would see something similar would be something closer to 50 basis points, but that's including some very, very rough times in commercial real estate. Is your point here that you would look at those periods and say they're not representative of BMO's current business mix and practices?

Pat Cronin, Chief Risk Officer

Yeah. I guess maybe I wouldn't read too much into the consistent with long-term averages. We could debate on what the right long-term average is. My main point was at 16 basis points that's a really good number from a loss rate. Whether you look at versus really rough times or even relatively benign times that's a really good loss rate for a commercial portfolio. And clearly in really rough times like a financial crisis it can get worse, but I don't expect that to occur in the next year, which is why I'm comfortable that we'll see that kind of a level continue for the next three or four quarters.

Operator, Operator

Thank you. The last question will be from Darko Mihelic with RBC Capital Markets. Please go ahead.

Darko Mihelic, Analyst

Hi. Thank you. Good morning. My questions are for Pat. Pat when I hear you speak about transportation finance and the natural gas segment, it sounds to me like there's been a significant increase in credit risk. And therefore, what we should see is movement into stage 2 a lifetime loss recognized against it. And then going forward, if they do fall into impaired well we'll see a stage 3 but the net impact should be much less in the future. I can't tell. When I look at page 28 of your supplemental, it doesn't look to me like that's occurred, so I'm confused a little bit. And perhaps you can also help me understand a little bit with respect to what happened this quarter. So in other words, how many of the files that hit this quarter came immediately from stage 1 into stage 3? And how many of them were actually in stage 2 last quarter?

Pat Cronin, Chief Risk Officer

Yeah. I guess, it's – we probably don't have enough time to go into a file-by-file decomposition. I would say, you did see some of the stage 1 and 2 migration this quarter. And I can tell you of those balance increases in both stage 1 and stage 2 roughly about 60% was credit migration 40% was balanced growth. But from 1 to 2, there was a concentration in that migration in oil and gas and transportation finance and then a bit in some of the other sectors as well. And so it's certainly not broad-based. What you might have seen this quarter in provisions as well keep in mind that some of those PCLs can come from things that are already in stage 3, where we took a provision in a prior quarter and then that provision was increased in this quarter due to factors like we've gone a long way through a liquidation process and the outcome turned out to be slightly worse than we thought. And that was the case this quarter as well. We actually saw some PCLs coming out of stage 3 and then as well some that went from stage one and into 3.

Darko Mihelic, Analyst

So is it fair to say that you have already migrated a significant proportion of these accounts into stage 2 and that is what gives you comfort going forward that even if they fall into stage 3 you've already got a significant reserve against natural gas and transportation finance? Or is that not the case?

Pat Cronin, Chief Risk Officer

No, that is the case. And I look at something like say the watch list in the oil and gas space. The watch list in oil and gas actually went down in this quarter versus Q4. So that to your point that is, because we moved it into impaired status and took the provisions that we thought. It doesn't guarantee, as I said earlier that, we don't see further provisions coming. There is potential for more migration. It will be concentrated in U.S. gas, but things are fairly stressed there. But outside of that, as I said, we don't see a lot and that's what gives me some comfort around the guidance that, I've given for the next couple of quarters on what those losses could look like.

Darko Mihelic, Analyst

Okay. And last question then. Is there – can you maybe provide a bit of a quantum in terms of if I have a stage two provision against a natural gas or a transportation finance and it were to migrate to stage 3, what's the quantum of difference? Is it that the increase in the PCL once it hits stage 3 would be another 10%? Would it be 50%? Do you have any sort of rough idea? Or any – what we've seen so far is maybe perhaps looking at the historical. Can you give us an idea? I mean, that ultimately is what's going to give us comfort that the future provisions really should be light given the fact that you're going from stage 2 to stage 3. And the difference between the two is nominal? Or is it not nominal?

Pat Cronin, Chief Risk Officer

It's really going to be decided on a case-by-case basis as you can imagine. Stage 2 tends to be more formulaic regarding the provisions. When we reach stage 3, we start examining the specifics of asset value, asset coverage, sale valuations, and similar factors for that particular name. Therefore, it’s challenging to make a comparison in the way you’re asking for.

Darko Mihelic, Analyst

But your experience so far? Do you have any kind of insight you can share?

Pat Cronin, Chief Risk Officer

Yeah. Generally, speaking I would say, the provision that we take in stage 2 is probably not that dissimilar to what you might see. On average over the longer term for the provision will ultimately take in stage – once it gets into impaired.

Operator, Operator

Thank you. There are no further questions registered at this time. I would now like to turn the meeting over to Darryl White.

Darryl White, CEO

Okay. Thank you, operator. In summary, I want to come back to where I started. This was a very good quarter for BMO at 4.6% operating leverage. And when I look across all of our businesses, all of our businesses performed well, closer to their longer-term potential. We're seeing new levels, as you heard through the call of earnings run rate expectations, particularly from our wealth and capital markets businesses. You also heard that PCL was elevated, but we earned through it and we expect it to come down next quarter and for the balance of the year. We're investing and driving revenue in key competitive growth areas while maintaining our commitment to 2% or less expense growth for the year, with continued progress on our efficiency ratio. Everyone at BMO understands that being more efficient makes us more competitive and even better positioned to drive long-term strong relative financial performance. Our commitment to our clients and our purpose is unwavering. Recently, we sadly lost one of the greatest champions of that purpose. So, on behalf of all of us at BMO, I want to take a moment to formally acknowledge the passing of a great friend, a great business leader and a true statesman Mr. Jacques Menard. He was an architect of the Canadian broker-dealer industry, a figurehead for our bank in its home province of Québec and a model of purpose-driven leadership for all. He will be greatly missed. Thank you all for participating in today's call. We look forward to speaking to you again in May. Thank you.

Operator, Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. Thank you for your participation.