Earnings Call Transcript
ROYAL BANK OF CANADA (RY)
Earnings Call Transcript - RY Q2 2023
Operator, Operator
Good morning, ladies and gentlemen. Welcome to RBC's Conference Call for the Second Quarter 2023 Financial Results. Please be advised that this call is being recorded. I would like to turn the meeting over to Asim Imran, Head of Investor Relations. Please go ahead, Mr. Imran.
Asim Imran, Head of Investor Relations
Thank you, and good morning, everyone. Speaking today will be Dave McKay, President and Chief Executive Officer; Nadine Ahn, Chief Financial Officer; and Graeme Hepworth, Chief Risk Officer. Also joining us today for your questions, Neil McLaughlin, Group Head, Personal and Commercial Banking; Doug Guzman, Group Head, Wealth Management and Insurance; and Derek Neldner, Group Head, Capital Markets. As noted on Slide 1, our comments may contain forward-looking statements, which involve assumptions and have inherent risks and uncertainties. Actual results could differ materially. I would also remind listeners that the bank assesses its performance on a reported and adjusted basis and considers both to be useful in assessing underlying business performance. To give everyone a chance to ask questions, we ask that you limit your questions and then requeue. With that, I'll turn it over to Dave.
Dave McKay, CEO
Thanks, Asim. Good morning, everyone, and thank you for joining us. Today, we reported second quarter earnings of $3.6 billion or adjusted earnings of $3.8 billion. Pre-provision pretax earnings of $5 billion were up 1% from last year. We also announced a $0.03 or 2% increase in our quarterly dividend as part of our cadence of twice-a-year increases in commitment to returning capital to our shareholders. Net interest income was up 16% from last year, benefiting from solid client-driven growth in Canadian Banking, and wealth management as well as higher interest rates. Capital Markets had yet another strong quarter, reporting over $1.1 billion in pre-provision pretax earnings despite a challenging environment for global investment banking fee pools. The revenue contribution was equally split between Global Markets and Corporate Investment Banking, reflecting the segment's well-diversified business model. Our all bank performance this quarter reflected the strength and diversity of our leading client franchises and strong balance sheet; however, shifting client deposit preferences, expenses and provisions for credit losses point to an increased cost of doing business. Before I provide context on our key growth strategies and the expense trajectory, I will speak to what remains a complex environment. Markets are facing structurally different circumstances following the end of an era of low inflation, low interest rates and increased globalization. This is in addition to absorbing challenges from technology and decarbonization as well as more near-term risks, including implications from U.S. debt ceiling negotiations. While recent stresses in the U.S. regional banking sector appear to have eased, the fallout will likely include more liquidity and capital regulations as well as a subsequent tightening of lending capacity. The Canadian financial system is already subject to many of these liquidity and capital requirements and performed exceptionally well through the recent U.S. regional banking liquidity crisis. It appears that the magnitude and steepness of Central Bank rate hikes have started to rein in headline inflation. Given signs of softening consumer demand for discretionary goods and rising debt service costs, we continue to forecast a mild recession, partly due to the lagging impact of higher interest rates on economic activity. However, with labor markets remaining firm despite declining levels of attrition and job postings combined with higher jobless claims, we do not expect central banks to cut interest rates through 2023. It's important that inflation does not become anchored into the psyche of the economy. The importance of balance sheet strength comes to light in these challenging moments and it is in this environment that we strengthened key ratios, including ending the quarter with a CET1 ratio of 13.7%. Looking ahead, we continue to expect that our CET1 ratio will remain above 12% following the close of the planned HSBC Canada transaction pending regulatory approval. We expect the transaction to close in the first calendar quarter of 2024. This mutually agreed upon timeframe will help us ensure a smooth transition for clients. In addition, the purchase price is structured using a lock box mechanism. And accordingly, all of HSBC Canada's earnings from June 30 to 2022, to close will accrue to RBC. We remain comfortable with the synergy and accretion assumptions we made at the time of the acquisition. Another important pillar of RBC's balance sheet strength is the addition of a further $173 million of provisions for credit losses (PCL) on performing loans this quarter. We've now increased our allowance for credit losses (ACL) on performing loans by over 20% since last year. We also have a diversified funding and liquidity profile, which includes our leading Canadian deposit franchise built on deep client relationships. Canadians appreciate the client value proposition that we offer including RBC Vantage, our partnerships and leading digital banking capabilities. Nomi forecast was recently recognized for best use of AI for customer experience at the 2023 Digital Bank Rewards. Furthermore, we entered into a strategic partnership with Conquest Planning to leverage its artificial intelligence platform to identify financial strategies for clients. Our clients also value our continuum of alternative offerings. In the current environment of higher interest rates and increased uncertainty, our clients are looking for both safety and yield. We continue to see a shift in personal deposit mix towards term GIC products. In the quarter, personal term deposits saw $10 billion of inflows, of which one-third were from external sources. GICs have seen nearly $50 billion of deposit flow over the last 12 months alone. We're also seeing a shift in mix for business deposits at the same time as we're seeing continued competition for assets. While there's been a significant trade-off to near-term margins, we have gained new clients to provide valuable advice to deepen relationships, which will become increasingly profitable over time. Furthermore, we expect to retain most of these balances and look to support our clients in reallocating their assets into our leading investment franchises at the right moment. These deposits are also an added source of lower-cost retail term funding as we continue to support our clients' financing needs. Our Canadian banking loan-to-deposit ratio has remained relatively flat and near 100% over last year. While Nadine will get into the details, I want to provide my thoughts on the expense trajectory. Reported expense growth was 16% year-over-year. However, after excluding acquisition and macro-related factors, expenses were up 8% from last year. The largest driver of expense growth this year has been higher headcount to support client needs as well as base salary increases. We are committed to actively reducing expenses through a number of different levers. This includes deliberate actions that we've already initiated such as managing headcount growth through attrition and slower hiring while also preparing for a complex transition with respect to the planned acquisition of HSBC Canada. The remainder of the core drivers of expense growth reflects inflationary pressure and importantly, strategic investments to enhance our value proposition and infrastructure to drive future operating leverage and client-driven growth, which I will speak to shortly. In addition to driving strategic growth and accretive capital allocation, one of my top priorities is an increased discipline around costs. The entire leadership team is committed to actively executing on our efficiency playbook we are focusing on curtailing expense growth and prioritizing investments without impacting our ability to serve our clients or our opportunities to attract new clients. I will now speak to key growth drivers across our largest segments. Starting with Canadian Banking, mortgages grew 7% from last year, down from 8% growth year-over-year last quarter. Origination activity is expected to continue moderating towards 2019 levels as limited supply and increased demand from immigration is muted by concerns around affordability. We expect annual mortgage growth to slow to the mid-single digits. Earlier this quarter, we announced the acquisition of OJO Canada, a fintech that supports Canadians at every stage in their home buying journey, including providing connections to real estate agents. We're also investing to enhance the efficiency of our mortgage lending platform. While credit card balances reached a record high of $20 billion with record new card openings, revolver levels remained below pre-pandemic levels. We expect revolver balance levels to surpass pre-pandemic levels by early 2024, which would have positive implications for net interest margins. Business loans were up over 15% from last year as we continue to see improving utilization levels in operating facilities and CapEx investments. The growth was balanced for the majority non-CRE related. We expect business lending growth will continue over the next few quarters. Moving to Canadian Wealth Management. Assets under administration were up 4% from last year, hitting a record level of $540 billion. We also recently announced we will bring over all adviser teams from Gluskin Sheff and part of the agreement also includes the distribution of Onex's alternative investment strategies and funds. And going forward, we will look to continue expanding our set of alternative asset strategies, which currently includes a partnership with QuadReal and our BlueBay family of funds. Despite challenging market conditions, RBC Global Asset Management assets under management increased from last quarter and last year while also generating positive net flows in the quarter. U.S. Wealth Management assets under administration also up from comparative periods. Adviser recruiting will remain a key source of growth for Wealth Management USA, and we added over 20 new advisers this quarter. Since the beginning of fiscal 2022, we've recruited 135 advisers who are expected to drive over $20 billion of assets under administration. We also look forward to future contributions from RBC Brewin Dolphin. In the midst of volatile backdrop in U.S. Regional Banking, City National deposits were down from last year as clients put their money to work, but most importantly, deposits remained stable sequentially. This is evidence of the new client relationships and the strength of the RBC balance sheet. City National loan growth was up 14% year-over-year with our mid-market strategy based on a diverse foundation of over 200 relationships. Going forward, we expect loan growth to slow as the focus increasingly shifts to improving business profitability while we continue to invest in enhancing City National's technology and governance infrastructure. Markets generated $1.1 billion of pre-provision earnings despite declining global fee pools, which are down over 40% from last year due to the economic environment. In Investment Banking, we continue to invest in talent in key verticals such as technology and healthcare as well as across important bridge areas, including M&A and equity capital markets. These investments are increasingly reflected in new mandates as well as in our market share, which has improved to seventh place so far in 2023, up from tenth through 2022. We are looking to strategically add further hires in key positions. We are also building out our U.S. cash management business, which we expect to provide a steady source of revenue and additional deposit funding capacity over time. We are excited about this opportunity and look forward to sharing more over the coming quarters as we look to launch the market. We believe we can meaningfully compete in this space given our existing corporate banking client relationships and leading credit ratings. In Global Markets, we aspire to continue gaining market share over time. We are currently investing in technology to further modernize our client tools and infrastructure to drive scalable growth in the future. In closing, while we continue to operate in the challenging macro and operating environment, we have momentum and are seeking meaningful gains across our core client franchises. We are focused on enabling future growth, including through our intended acquisition of HSBC Canada and moderating our expense growth to sustain our premium valuation. Before I turn the call over to Nadine, I do want to express our support for Western Canada in light of the ongoing wildfires across the region. We have contributed to the Canadian Red Cross relief efforts and are supporting our communities, clients and employees in the impacted areas. Nadine, over to you.
Nadine Ahn, CFO
Thanks, Dave, and good morning, everyone. Starting on Slide 8, we reported earnings per share of $2.58 this quarter, adjusted diluted earnings per share of $2.65 was down 11% from last year, largely driven by the impact of prior year releases of provisions for credit losses (PCL) on performing loans. Strong client-driven revenue growth of 20% year-over-year or up 10% net of PBC AE was largely offset by higher expenses, resulting in pre-provision pretax earnings growth of 1%. Before focusing on more detailed drivers of our earnings, I will highlight the strength of our balance sheet. Starting with our strong capital ratios on Slide 9, our CET1 ratio improved to 13.7%, up 100 basis points from last quarter. Consistent with the guidance we provided in Q1, this quarter's increase reflected a 79 basis point benefit from Basel III regulatory reform. Next, turning to Slide 10, it is important to emphasize the diversity, strength and stability of our funding and liquidity profile. This quarter, we prudently managed to a higher liquidity coverage ratio (LCR) of 135% up 5 points from last quarter, which translates into a surplus of $102 billion. Our liquidity levels remain robust and provide us with flexibility to execute our strategy. Turning to our $900 billion client deposit franchise. Canadian Banking accounts for approximately 70% of total client deposits. Our Canadian retail banking franchise is well diversified, serving approximately 13 million personal banking clients with the median checking account balance of $2,000. Furthermore, over 85% of our mortgage clients have a personal banking account increasing the depth of the relationship. In the U.S., as Dave noted, City National deposits remained stable quarter-over-quarter, and our U.S. Wealth Management franchise has over $30 billion of sweep deposits. Across our North American corporate and commercial deposit franchises, we have long-tenured, relationship-based clients that we support with strong advice and a deep shelf of products and solutions. The combination of our strong deposit base and robust capital positions us well to continue funding future loan growth and meeting the needs of clients. Moving to Slide 11. All banks net interest income was up 16% year-over-year or up 19% excluding trading revenue. These results reflect our earnings sensitivity to higher interest rates as well as the benefit from higher volumes across many of our Canadian Banking and Wealth Management businesses. All bank net interest margin excluding trading net interest income and assets was 7 basis points from last quarter, largely reflecting positive trends in our North American Personal and commercial banking franchises as well as higher enterprise liquidity levels. On to Slide 12. We walked through this quarter's key drivers of Canadian Banking net interest margin (NIM), which was down 8 basis points from last quarter. The embedded advantages of our structural low-beta core deposit franchise continued to come through this quarter, reflecting the latent benefit of recent interest rate hikes. NIM also benefited from changes in asset mix including higher credit card revolving balances and strong commercial growth. While we have seen a slight widening of mortgage spreads from historically low levels, mortgage lending remains highly competitive. However, these benefits were more than offset by both the continued shift in deposit mix into term products, along with lower GIC spreads, reflecting increased competition for non-wholesale term funding. Going forward, we now expect low double-digit net interest income growth for 2023. However, there are a number of variables that drive this outlook. Embedded in our guidance are modeled expectations for client behavior, including solid volume growth, a slowing in the continued deposit mix shift towards GICs and a favorable asset mix shift towards higher spread commercial and credit card loans. With respect to spreads, we assume continued intense competition for deposits and mortgages and flat interest rates. Any changes in the timing and extent of these spread and volume assumptions could have an impact on the trajectory of net interest income. Turning to City National, NIM was down 22 basis points from last quarter, mainly reflecting an adverse funding mix shift into interest-bearing deposits as well as a full quarter's impact of last quarter's higher Federal Home Loan Bank (FHLB) borrowings. This more than offset the significant benefit of Federal rate hikes on City National's asset-sensitive balance sheet. Moving to Slide 13. Non-interest expenses were up 16% from last year. Approximately half of this growth was driven by acquisition-related costs as well as macro-driven factors such as foreign exchange and share-based compensation. Beyond these factors, the core drivers of organic expense growth were investments in people and technology. Salaries were up 20% from last year as investments in our people reflected full-time equivalent growth of 10% year-over-year as well as inflationary impacts of the higher base salaries announced last year. This trend was most evident in Canadian Banking as elevated hiring to service increased client needs and to offset the higher-than-average employee attrition rate has led to full-time equivalents being 2,600 higher than last year. In Capital Markets, expense growth was underpinned by investments in upgrading our technology and building out product capabilities that Dave highlighted earlier as well as higher costs in support of increased activity including trade execution. At City National, we continue to make investments in people, processes and technology to enhance the operational infrastructure in support of the bank's next leg of growth. More broadly, business development costs such as marketing and travel expenses continued to grow off of COVID-related troughs. We are increasingly focused on controlling expenses through various levers including actions to manage headcount while also curtailing discretionary spending. We are also taking action to centralize certain operations, rationalize vendor relationships and prioritize certain application development spend. Looking ahead to the second half of the year, we expect adjusted all bank expense growth, excluding acquisition-related costs and share-based compensation to decelerate to the mid-single digits. In Canadian Banking, we remain committed to leveraging our scale in achieving a sub-40% efficiency ratio. Moving to our segment performance, beginning on Slide 14, Personal & Commercial Banking reported earnings of $1.9 billion this quarter with Canadian Banking pre-provision pretax earnings up 11% year-over-year. Canadian Banking net interest income was up 16% from last year, due to higher spreads and solid average volume growth of 8%, reflecting balanced growth in loans and deposits. Non-interest income was flat year-over-year as higher service charges and forward exchange revenue driven by higher client activity was offset by lower mutual fund distribution fees, reflecting the challenging market conditions which weighed on average mutual fund balances. Turning to Slide 15. Wealth Management earnings were down 8% from last year due to higher PCL on performing loans and elevated expense growth in U.S. Wealth Management. In contrast, non-U.S. wealth management expenses were largely flat year-over-year, excluding the impact of RBC Brewin Dolphin. Revenues were up 11% year-over-year, aided by robust net interest income growth of 25%, reflecting the benefit of higher rates in both Canadian Wealth Management and U.S. Wealth Management. Global Asset Management revenue decreased primarily due to lower average fee-based client assets on the back of softness in global markets. Despite challenging market conditions, net sales turned encouragingly positive, driven by flows into institutional long-term and money market funds. Turning to Slide 16. Cash earnings were up 10% year-over-year reflecting strong formats in its volatile markets and the benefit from a lower tax rate. Investment banking revenue was up 4% from last year as a reversal of underwriting marks and increased client activities in municipal banking were partly offset by industry-wide declines in global fee pools amidst macro uncertainty. Global Markets revenue was down 3% from last year as lower equity trading revenues across regions were largely offset by broad-based strength in fixed income trading. Lending and other revenue was up 17% from last year, reflecting strong results in transaction banking, underpinned by margin expansion and higher lending revenue driven by mid-teen loan growth. Turning to Insurance, net income decreased $67 million or 33% from a year ago, primarily due to higher capital funding costs. To conclude, we are confident that the strength of our capital, credit and funding profile, combined with the strategic investments being made today will create long-term value for shareholders. And we are committed to driving towards our objective of positive operating leverage. Our full management team is focused on expense optimization and moderating our expense growth in light of the rapidly changing macro environment. With that, I'll turn it over to Graeme.
Graeme Hepworth, Chief Risk Officer
Thank you, Nadine, and good morning, everyone. Starting on Slide 19, I'll discuss our allowances in the context of the macroeconomic environment. During the quarter, we saw elevated volatility stemming from issues in the U.S. regional banking sector. However, the trajectory of the overall macroeconomic environment was consistent with our expectations. Inflation continues to moderate and central banks appear to be nearing the end of their rate-hiking cycle. Relative to this time last year, the probability of more severe inflation and interest rate outcomes has reduced. That said borrowers have been dealing with a higher rate environment for several months now. We are seeing insolvencies, impairments and losses increasing toward longer-term averages. The full impact of higher rates in the economy will take time to translate into credit losses. We are still in the early stages of the credit cycle we've been expecting for some time. As a result, we built reserves on performing loans for the fourth consecutive quarter. This quarter's provisions reflect the impacts of increasing levels of delinquencies and credit downgrades, lower forecasted housing and commercial real estate prices and portfolio growth. In the retail portfolio, most of this quarter's provisions on performing loans were taken on credit cards and unsecured revolving loans. The credit losses have been faced to normalize consistent with the traditional credit cycle. In the wholesale portfolio, the majority of our provisions on performing loans were taken in commercial real estate. As I discussed last quarter, risk in this sector continues to increase, driven by higher interest rates, weakening macroeconomic factors and behavioral trends. Having said that, our commercial real estate portfolio is well diversified, it has been originated to sound underwriting standards in support of a strong client base. With additional reserves added this quarter, our ACL on performing commercial real estate loans has increased 77% from a year ago. We remain sufficiently provisioned building our International Financial Reporting Standards 9 (IFRS 9) downside scenarios, reflecting a decline in commercial property values ranging from 15% to 40%. In total, our allowance for credit losses on loans increased by $328 million this quarter to $4.8 billion. Moving to Slide 20. Provisions on impaired loans were up $84 million or 4 basis points relative to last quarter. I would note that our PCL ratio of 21 basis points remains below pre-pandemic historical averages. In our wholesale portfolios, provisions were up $74 million compared to last quarter, with increases in capital markets and the Canadian Banking commercial portfolios. So far this year, the majority of our losses in the wholesale portfolio have been from clients that had issues prior to or due to the pandemic. Late increases have subsequently acted as a catalyst for these borrowers to become impaired. As we move further into the credit cycle, we expect to see losses driven by more systemic factors arising from the anticipated economic slowdown. In our Canadian banking retail portfolio, provisions increased by just $10 million quarter-over-quarter. This portfolio continues to benefit from persistently low unemployment rates and elevated client deposits. Notably, provisions on impaired residential mortgages were lower this quarter as the rate environment stabilized and clients continue to prioritize payments on their mortgages. As expected, a large majority of the PCL impaired loans was driven by credit cards and unsecured lines of credit, which as I noted earlier, is consistent with expectations from a traditional credit cycle. Moving to Slide 21. Gross impaired loans were up $294 million or 3 basis points this quarter, with the increase primarily driven by Capital Markets and Canadian Banking. This marks the third consecutive quarterly increase in gross impaired loans, and our gross impaired loan (GIL) ratio of 34 basis points remains below pre-pandemic levels. Additionally, new formations decreased compared to last quarter across all our major lending businesses. To conclude, we continue to be pleased with the ongoing performance of our portfolios. As expected, our PCL ratio on impaired loans continue to increase remains below pre-pandemic levels at historical averages. The impact of inflation and higher rates is expected to play out over a number of years, and we are still in the early stages of the current credit cycle. We expect PCL on impaired loans to continue to increase through the remainder of this year. Last fall, I guided toward a range of 20 to 25 basis points for PCL on impaired loans. We are expecting to come in at the higher end of that range for the year. Ultimately, the timing and magnitude of increased credit cost continues to be pending Central Bank success in curbing inflation while creating a soft landing for the economy. We continue to proactively manage risk through the cycle, and we remain well capitalized to extend plausible yet more severe macroeconomic outcomes. And with that, operator, let's open the lines for Q&A.
Operator, Operator
Thank you. We will now take questions from telephone lines. The first question is from Meny Grauman from Scotiabank. Please go ahead.
Meny Grauman, Analyst
I just wanted to touch on expenses. Dave, you talked about some of the levers that you have at your disposal to slow expense growth. One thing you touched on was attrition. My understanding is that companies are seeing attrition rates come down very significantly, which makes sense in the current environment. I'm wondering what you're seeing and how significant attrition can really be in your goal of getting expenses down?
Dave McKay, CEO
Fair question and maybe I'll go back; it's such an important part of our overall construct of improving our premium performance. First, I think we have to acknowledge that we have a number of complex strategic programs underway. HSBC, which is front-loaded, but not all of HSBC's costs could be quantified within a separate project. For example, Neil would be carrying more call center employees and maybe some more branch employees just to get ready for the conversion process. So there are some embedded costs in the business. There are the majority of the systems costs obviously we can isolate to do that. So there are some carry-on effects to getting ready and spending all that money upfront to get ready for an HSBC, a smooth HSBC conversion. We are still seeing attrition; to your point it is slowing. Having said that, we've seen our numbers turn negative month over month. So I think there is a way to manage this down while balancing the significant strategic programs we have in front of us. Don't forget, we're also in the process of selling and detaching our investor services business in IS Bank, which is a complex technology play we've got Brewin Dolphin, so we have a number of strategic initiatives that blend in a little bit. But having said that, we took Nadine's point on moving this down to mid-single digits or better, and we feel confident in managing all aspects of our cost base, including hiring. Like some other banks in the U.S., you've heard over the last few quarters, that this is a very difficult transition from the volatility and supply/demand shortages in the market that were very prevalent last year. We had to react strongly in the latter half of 2022 to staffing shortages given the technology firms, the tech firms are hiring so aggressively in the latter part of 2022. We had to respond to that with aggressive hiring and anticipating high turnover rates persisting into the first half of 2023. Well, that was not the case; almost overnight the tech firms started laying off instead of hiring, and therefore, attrition came off very rapidly, and honestly, we overshot. We overshot by thousands of people. Some of those people, as I said, are there to help us make the transition with HSBC, and some will come off through attrition. So I think we were caught a little bit by how quickly the labor markets changed in Canada and in the U.S., but largely Canada. We're adjusting to that overhang right now, and we feel we can manage this through all the levers that we have, but we're going to come at it aggressively. If one method doesn't work, we have other plans and strategies to back that up to make sure that we address this. So, thank you for that question; it's an important construct to some of the challenges we faced this quarter.
Meny Grauman, Analyst
And just a follow-up, just to understand the timing in terms of what's realistic, given all the moving parts that you're talking about. What's the timeline for saying mission accomplished here from your perspective?
Dave McKay, CEO
We're definitely expecting to see more significant improvement in Q4, but Q3 will be a transition quarter. We still expect to have strong overall performance in the latter half of this year. But we're going to execute a lot of this in Q3, and we expect a much better Q4. But, Nadine, do you want to add to that?
Nadine Ahn, CFO
Yes. No. Obviously, given the headcount and coming off of Q1, we've been implementing into Q2, some of the cost reductions we already spoke about, but that's going to take a couple of quarters to really start to impact. So that's why, Meny, we're commenting that the mid-single-digit non-interest expense (NIE) growth will be for the second half, but staggered more towards Q4.
Operator, Operator
Thank you. The next question is from Gabriel Dechaine from National Bank Financial. Please go ahead.
Gabriel Dechaine, Analyst
I would like to inquire about the deposit growth trends in the Canadian bank. It seems to me that Royal is making significant efforts to attract more deposits. What drives this focus? Is it to gain market share? Are you aiming to convert some of these customers into core banking customers? Or is it influenced by various factors, such as the structure of your business? You have a larger wealth franchise and the largest independent broker business in Canada, so some of the deposits from wealth and broker activities might greatly impact your deposit growth, which has both positive and negative implications.
Neil McLaughlin, Group Head, Personal and Commercial Banking
Yes, thanks, Dave, it's Neil. I'll address this. The first point is about new client acquisition, which aligns with the goal we set during Investor Day to expand our core checking account business. We view this as stable funding, and it has been performing exceptionally well. This success contributes to the increased costs we've experienced in the last couple of quarters. Last year, we had reduced our marketing and business development efforts because the returns were not favorable. However, this quarter, we achieved our best Q2 ever in terms of acquiring new clients. The second point relates to our overall franchise. We have a substantial financial planning business that benefits from Global Asset Management and strong investment product development. We're observing a rotation in GIC growth, with about half of that growth coming from outside the company. This indicates that a considerable portion of new clients is being attracted through our advisory sales teams. Our goal is to transition these clients into long-term investment funds once the equity market stabilizes. About half of the growth is also derived from internal sources, mainly savings and core checking accounts. This captures the flow and mix, which includes new clients, external consolidation, and internal rotation.
Gabriel Dechaine, Analyst
Okay, and then a quick one on expenses. Just the way you display at 16% growth, about half of that, I get calling out the HSBC acquisition, but why should I look at Brewin Dolphin in a distinct manner because it's in the revenue line as well?
Nadine Ahn, CFO
Agreed, Gabe, from an operating leverage standpoint; you're absolutely correct. We're just trying to explain the non-interest expense (NIE) growth trajectory since the comparative on a year-over-year basis, sometimes highlight.
Operator, Operator
Thank you. The next question is from Mario Mendonca from TD Securities. Please go ahead.
Mario Mendonca, Analyst
Can we go to Slide 15 where you show the decline in your wealth deposits? That 15% sequential decline in deposits is noticeable. So, it's a big number. Help me understand how you fund that kind of deposit attrition? Is it through selling securities and maybe about where these deposits are going, presumably, they're not leaving the bank entirely. Help me think that through.
Nadine Ahn, CFO
It's Nadine. I'll take that one, Mario. A lot of the issue is related to the deposit mix in City National. We've observed an overall attrition as there has been a shift from non-interest-bearing deposits to interest-bearing ones. We've been managing this through our broker CDs. The loan book trajectory has decreased slightly. However, when you examine our balance sheet for City National, we've increased our loan-to-deposit ratio from about 73% to 88%. Regarding the deposits coming off, there is a noticeable shift towards higher-cost funding sources. For instance, we've tapped into our FHLB primarily to enhance our overall liquidity position. It's not that we are reducing our asset base; instead, we are increasing it with higher-cost funding, which is why you've observed a quarter-over-quarter drop in the net interest margin.
Mario Mendonca, Analyst
That's that '22 or whatever, maybe not '22. That's a meaningful drop in City National Bank's margin is reflective of this deterioration in deposits that I referred to. Those you'd connect those two presumably.
Nadine Ahn, CFO
Correct. Year-over-year, we would also have excluded Investor Services. Moving that to a deposit balance sheet base to available for sale would reflect this on a year-over-year basis.
Mario Mendonca, Analyst
Okay. My follow-up question relates to the LCR. That's a significant sequential increase of 5 points. Can you provide an estimate of how that impacts the overall bank margin in a given quarter? Specifically, with the LCR increasing by 5 points, what does that mean for the margin?
Nadine Ahn, CFO
Yes. Overall, you are looking at a shift from approximately an $88 billion surplus to around $102 billion, which is roughly at a cost of about 55 basis points. From an overall bank margin perspective, this wouldn't be very significant, perhaps around 1 basis point.
Doug Guzman, Group Head, Wealth Management and Insurance
Just back on the deposits, Mario, if you look in the footnote on that page, over half of that move is that IS change that Nadine mentioned.
Gabriel Dechaine, Analyst
Yes.
Nadine Ahn, CFO
On a quarter-over-quarter basis, the City National deposits were flat, if you think about it from the mix shift from an FHLB funding increase.
Operator, Operator
Thank you. The next question is from Doug Young from Desjardins Capital Markets. Please go ahead.
Doug Young, Analyst
Good morning. Maybe for Derek, Capital Markets seems to have bucked the trend here. Hoping you can maybe talk a bit about the drivers. I think there was some impact from market reversals, if you can quantify that. And I know it's tough to kind of pull up the crystal ball, but I'll throw it out there. You have a $1 billion pretax pre-provision earnings target quarterly that you kind of set. How do you feel relative to that, given the business pipeline and then maybe you can mention just you're building out a cash management strategy here. How does that impact that outlook as well?
Derek Neldner, Group Head, Capital Markets
Sure. Thanks, Doug. I'll start with the macro drivers. Overall, we believe we benefited this quarter from the diversified nature of our platform. Despite fluctuations in activity across different products, this diversification has helped us remain strong in certain areas. Additionally, the strategic changes and investments we've made over the past three years are contributing to market share growth, which is helping to offset some of the weaker fee activity. For specific areas, we had a solid quarter in our Sales & Trading business, driven by our macro business due to the volatility in interest rates and foreign exchange markets, along with our credit business. Last year, we had a strong credit trading franchise, which faced challenges as credit spreads widened. However, with more stabilization this year, that business has performed well. In our corporate banking segment, we've maintained a disciplined growth strategy, resulting in moderate year-over-year growth, especially given the previous year's performance. The addition of the transaction banking business into the Capital Markets segment has also done well in the higher interest rate environment. Regarding investment banking, we've successfully gained market share year-over-year, moving up to seventh place across core products, which has helped mitigate a slower fee pool. Additionally, we have a very strong U.S. municipal finance franchise, with good activity in the muni market over the quarter. It's not just one factor, but rather a variety of businesses that performed well and contributed to our success. Concerning the underwriting mark-to-market, last year was challenging for us with significant marks. However, as the market has improved and we've been disciplined with our portfolio, we've recovered some of those losses. While I can't disclose the exact mark-to-market change, there are one-off items that have benefited us, and I estimate this to be around $50 million in positive revenue. While it helped us achieve results, I wouldn't say it was the main driver. We're pleased to reach our target of $1.1 billion. In terms of outlook, we feel quite optimistic about the business. The trading businesses are normalizing but remain at a healthy run rate. We expect continued demand from our corporate clients for credit, ensuring steady revenue from the loan book. Early signs of recovery in investment banking fee pools are emerging. While I don't expect a rapid recovery, we are seeing improvements in Debt Capital Markets and Equity Capital Markets post-March. Our M&A backlog is healthy, though finalizing deals in uncertain conditions can be challenging. Importantly, we have various strategic initiatives that excite us, including cash management, and we are optimistic about gaining market share and driving growth beyond just broader economic conditions.
Operator, Operator
Thank you. The next question is from Ebrahim Poonawala from Bank of America. Please go ahead.
Ebrahim Poonawala, Analyst
I guess maybe a big picture question, Dave, trying to tie back to the ROE outlook. You mentioned how quickly the environment changed over the last six months. As you are managing the bank today, you talked about attrition, capital liquidity, just across all of these measures. What are you managing for? Are you managing for a mild recession, deep recession when you look out over the next year? And is the outlook different for the U.S. versus Canada? Just talk through all of that. And within that framework, how do you think in terms of the resiliency of the ROE relative to where we are today?
Dave McKay, CEO
Thank you for the important question, Ebrahim. We are currently forecasting and preparing for a mild recession, which is why we are implementing various strategies to manage our cost structure in light of attrition. Despite this, we still see robust demand from businesses and investments. Employment levels are strong, giving our consumer clients significant purchasing power. As I mentioned earlier, we are adjusting our strategies for a milder recession influenced by high interest rates and challenges related to debt servicing. It's crucial for us to exert strong control over inflation, which is a key priority for central banks, and we fully support that mission. Our strong capital ratios enable us to grow organically, and we are also on track to acquire HSBC Canada while maintaining levels above 12%. This is a significant strength for our balance sheet. Regarding deposits, which are essential for a bank's operations, we are the only bank in Canada that is match funded in Canadian dollars on the retail side, which enhances our margins over time. While there is a global trend of clients moving into higher-cost deposits, we are successfully retaining the majority of these deposits. It's important to highlight City National Bank, which remained stable or slightly improved during the recent crisis in the U.S., benefiting from a highly affluent and commercial client base that continues to trust in the organization. Despite fluctuations in the market, we saw new client growth during this time, as many individuals sought better yields. We are navigating these dynamics as we look at margins and revenue, and we are adjusting our cost structure accordingly. We anticipate growth despite the margin impacts associated with depositor strategy shifts. It’s essential that we quickly adapt to changes in volatility around hiring and our cost structure. Our strategy is to continue growing organically; we’ve experienced strong growth in capital markets and solid performances in both our U.S. and Canadian wealth divisions. Our Canadian retail franchise also saw notable organic growth, all supported by our strong capital performance. We expect our commercial business to bounce back as well. Looking ahead, we are focused on executing several complex strategic acquisitions. The HSBC acquisition is particularly intricate, as much of the labor occurs ahead of time. We expect the conversion and closing of this acquisition to take place in early 2024, and the necessary groundwork is already in progress. We are currently managing the costs and complexity of this acquisition while also handling the divestment of IS Bank, which is advantageous for our shareholders, and moving Brewin Dolphin. Overall, we are very optimistic about the organic growth prospects and the benefits of the HSBC acquisition, which we believe will add significant value for our shareholders from an M&A standpoint, supporting a strong ROE opportunity for us.
Ebrahim Poonawala, Analyst
And just on U.S. in terms of the market share opportunity, all did a great job post-GFC in the capital market side in the U.S. When you look at it right now, given what's happened with First Republic and SVB, are the better opportunities in private banking, the regional bank turmoil, does that create some commercial opportunities? Like do you see those? And like is RBC ready to act on those?
Dave McKay, CEO
Are you talking from an organic perspective?
Ebrahim Poonawala, Analyst
Organic
Dave McKay, CEO
Absolutely, we've run in a number of new relationships from both all those challenged banks and failed banks, as you've mentioned, and we'll continue to do so, whether it's through teams coming in or clients approaching us directly at City National and taking them on. Those accounts are starting to fund now so absolutely, there's a significant opportunity given the capital that we have to continue to grow organic. And that's our primary focus is to serve clients and integrate the HSBC acquisition. All that while remaining above 12%. I think it's a unique opportunity to create premium shareholder value and ROE.
Operator, Operator
Thank you. The next question is from Paul Holden from CIBC. Please go ahead.
Paul Holden, Analyst
First question for Graeme. With your revised PCL guidance or pushing to the upper end of the range, how are you thinking about commercial/corporate versus consumer? And I guess the reason I ask is consumer looks like it's still really strong for many reasons you've already cited, where we're seeing some pockets of weakness, I think, on the business side. So is there any clear differentiation between the two?
Graeme Hepworth, Chief Risk Officer
Hi, Paul, thanks for the question. And we're going to break those down. I would say on the retail side, I would show say retail has been trending consistent with our expectations overall. I would say this quarter that some of the trends we were seeing there started to decelerate and we saw some improvements, obviously, in the delinquencies I quoted. Having said that, we do expect retail to continue to increase as we go throughout the year because we're going to see a second leg of an effect here in terms of the employment environment, right? And so in our kind of baseline forecast, we do expect unemployment to tick up from the exceeding levels we're at right now. We're in that kind of 5.1 range. We expect that to kind of get into the mid-six range as we trend through the end of the year and into 2024. And so, we had very strong performance there and so the recent trends have been good. We do expect that will continue to increase as we progress through 2023. The wholesale side, certainly, we saw a tick up this quarter. Wholesale is never quite as linear and quite as predictable. It will kind of move up and down from quarter-to-quarter as we see certain files come in and impaired. We had a period through 2021 and 2022, where wholesale was exceedingly low; right? We were at kind of near-zero levels for a very extended period. And so last quarter, this quarter, we are starting to see the implications flow through corporate a little more, but I would say that's not unexpected. Although it just won't be quite as consistent and linear as we're seeing on the retail side. So again, on wholesale, similarly, we will continue to expect it to kind of trend back to more kind of longer-term averages as we progress through the year. So, the same economic factors will continue to play out in that space as we're seeing in retail, but it just won't be quite as consistent in the path to get there.
Paul Holden, Analyst
And then anything worrying some on the commercial side at all?
Graeme Hepworth, Chief Risk Officer
Commercial in Canada, you're saying specifically?
Paul Holden, Analyst
Commercial either side of the border are really, I guess, both, right? Like obviously, there's been a lot of discussion on CRE, and you provided some additional details there. Are there other pockets of concern on the commercial side?
Graeme Hepworth, Chief Risk Officer
I believe the main area of concern you've identified is commercial real estate, which has been our primary focus. We have conducted extensive analysis and work to ensure we are implementing the necessary rate actions I mentioned earlier. This was one of the reasons we increased our loan loss allowances this quarter, anticipating more challenges in that sector. The situation will take time to evolve, and different markets will respond in various ways. To put this in perspective, our allowance for credit losses ratios concerning commercial real estate are now approximately twice what they were before the pandemic. In a more typical environment, we would expect loss rates to also be around twice as high for the aggregate portfolio. The U.S. situation appears to be more acute, with our ratio there being about 2.5 times higher than in Canada, reflecting the institutional nature of our client base in the U.S. Nonetheless, we have a solid client base and good underwriting standards. In Canada, over 95% of our commercial real estate portfolio is guaranteed, so our clients are committed to working through these challenges with us. While we anticipate headwinds in commercial real estate, we expect the overall commercial portfolio to return to more normal levels as the year progresses.
Operator, Operator
Thank you. The next question is from Lemar Persaud from Cormark Securities. Please go ahead.
Lemar Persaud, Analyst
This maybe for Dave, but the other group has might want to chime in as well. I think you referred to increased regulation in the U.S. from the fallout that failed U.S. regional banks. I'm wondering if you can maybe offer your thoughts on how much of a magnitude is increased potential capital regulations, liquidity changes and tightening of lending capacity or impact to your U.S. operations. Are you guys actively making changes with respect to how you operate in the U.S.? And then it sounds like it's a net positive for City National, but then what about the capital markets business?
Dave McKay, CEO
I can begin by addressing the challenges facing banks, particularly in light of the ongoing discussions between the industry and regulatory leaders. We anticipate some modifications to liquidity or capital rules, or a combination of rules concerning positive concentration and overall liquidity levels. This includes how we manage asset durations and their impact on our balance sheets and equity base. As we look at the Canadian landscape, we recognize that these changes are expected and could influence industry margins and profitability, necessitating at least an increase in liquidity. This situation may indirectly affect City National Bank as well. Furthermore, there are expected recovery charges from the FDIC related to the costs incurred by Signature Bank and Silicon Valley Bank, with details for First Republic still pending. City National Bank will likely share in these recovery costs, though minimally. In the long term, it's essential to monitor our depositor concentrations, considering both insured and uninsured deposits, especially among commercial and ultra-high net worth clients. While our depositors have remained stable, unlike those at many other banks, this stability can be attributed to the strength of RBC alongside City National Bank. Nonetheless, we must be prepared for potential regulatory changes, even with the solid foundation we currently have. This might prompt slight adjustments in our strategy, as there is a heightened focus on securing more operational deposits and treasury management deposits. The market is fiercely competitive for these types of deposits, prompting us to evaluate the strength of our customer value proposition. As part of this strategy, we are launching a U.S. corporate cash management service to capitalize on our existing relationships with large corporations, particularly because we play a significant role in senior syndicates or have AA ratings. This initiative is expected to bolster our growth in the U.S. and support our funding needs. While we don’t expect to be unaffected at City National Bank, we believe we are well-positioned to adapt and will continue to strive for a balanced deposit profile over time. I hope this clarifies our perspective on these evolving concepts that we will monitor closely.
Graeme Hepworth, Chief Risk Officer
Maybe just jump in with one extra comment there, Dave. You'd asked about impact potentially the capital markets. I mean, I would just remind you that some of the standards that are being considered, the policy changes that Dave referenced, there are all standards in policies that RBC as a group is subject to inherently have to adhere to. And so in the U.S., likewise, our U.S. operations in aggregate have been treated as a large bank and subject to things like Comprehensive Capital Analysis and Review (CCAR), et cetera. And so, Capital Markets has been kind of living in a part of that for a long time. And so we would certainly expect the policy changes are uncertain at this point in time. Dave, as Dave indicated, there are impacts that the margin would be more in City National Bank and capital markets.
Dave McKay, CEO
And we aggregate City National into RBC. And therefore, all of those positions are already aggregated into our balance sheet and our income statement. So, it'd just be how they're distributed with it internally wouldn't be a top-of-the-house impact.
Lemar Persaud, Analyst
I'll limit myself to that just in the interest of time.
Dave McKay, CEO
That's an important question; thank you.
Operator, Operator
Thank you. The next question is from Joo Ho Kim from Credit Suisse. Please go ahead.
Joo Ho Kim, Analyst
Just a quick number for me. That NII growth target of low double-digit, but was that for all of 2023 or just the second half of the year?
Nadine Ahn, CFO
That would be a full year 2023.
Joo Ho Kim, Analyst
Okay, thanks. And just last one for me on your expense outlook for the remainder of the year. I'm just trying to get a sense of what the levers you have to do dial this down, and I think you've got a good job of quite talking about on the full-time equivalent side, but just wondering if capital markets expenses could play a big role here. I do see over the last few years, seasonal decline in capital markets expenses for the first half to the second half. So, I'm wondering, if we could see a similar dynamic play out this year and then whether that's a big driver of your expense growth follow?
Derek Neldner, Group Head, Capital Markets
Yes. Thank you. Good question. I mean, I'll tackle that a few ways. I think I would be careful a little bit looking at the last few years because as we've discussed on a few of the prior calls, given the volatility we saw coming through the pandemic and post, we saw more intra-year movement in our compensation accrual, where in 2021, we had a sort of larger accruals through the first part of the year, and we were able to scale that back in the second half. And then last year, with a number of the environmental surprises and challenges we saw in the second half, it was the opposite. So, we ended up having to increase our accruals through the second half. So the last two years, I would say the compensation was less linear throughout the year as we would normally like, and we are very focused on being more consistent or linear, if you will, on how we're accruing throughout the year. So, I would just maybe caution away from looking at that too much over the last few years. I think in terms of our expense profile overall, I think, first, we're actually there's more to do, but we're reasonably pleased with our expenses in the second quarter where you saw revenue was up 5%. Our expenses were up 6%. So, we did have negative operating leverage but a number of initiatives that we've been implementing have kept NIE to a reasonable level, taking into account some of the strategic technology investments, cash management investments, and other things we're doing. When you look at the second half of the year, given the revenue environment was quite weak for capital markets in H2 last year, we do expect very strong positive operating leverage in the second half. I think we will continue to execute on some of our cost programs. But in a stronger revenue environment than last year, which we expect, that should contribute to a very positive operating leverage in the second half.
Dave McKay, CEO
I think we have time for one more question.
Operator, Operator
Thank you. And the last question will be from Mike Rizvanovic from RBW Research. Please go ahead.
Mike Rizvanovic, Analyst
This one is probably best for Neil. I just wanted to go into the deposit growth since pre-pandemic in Canada in a bit more detail. So one thing that I think is a bit surprising is Royal underperformed the peer group a little bit on the demand and notice side? And then on the fixed term side, you've had a lot better growth than anyone else. So what's driven that underperformance in the demand and notice category, in your view?
Neil McLaughlin, Group Head, Personal and Commercial Banking
We've actually been growing our checking market share. So our core checking business in the Canadian retail bank is actually up over the last year. And I would say, in the last while, if we look on a combined demand and term basis, the market share is also up. So I think we do have a lot of confidence just about the momentum we see in consumer deposits. So that would be the take there. And I think part of that is also related to the new client acquisition we spoke of. I had mentioned earlier, we've had very aggressive targets in terms of new clients. And after the pause we put in place during the pandemic. We're back out playing offense, investing with that business development expense to drive that new client acquisition, and it's pulling well. So, we feel quite bullish on consumer deposits.
Mike Rizvanovic, Analyst
And just in terms of the mix shift. So, if I look at your demand and notice as a percentage of your total Canadian deposits as of March, this is just the OSFI data. You're about 5% lower than you were pre-pandemic. And this is the lowest level that I can see since 2012. I'm wondering how this mix sort of what's the trajectory going forward, assuming rates drop later this year, early next year? I'm just trying to understand do you now have maybe for having that bigger concentration in the demand and notice category than you maybe would typically see a benefit from? It looks like it's diminished a little bit. I'm wondering how that sort of moves from here.
Neil McLaughlin, Group Head, Personal and Commercial Banking
Yes, I've discussed the consumer side, and I can say we're seeing increased market share on both sides when comparing quarter-over-quarter and year-over-year. However, we are not entirely satisfied with the performance in higher-end commercial deposits, particularly regarding our cash management services for larger corporations. We have observed about a 10% shift in our commercial and corporate deposit balances into term categories, which is a strong trend. Additionally, we have noticed some large deposits leaving our energy sector for capital expenses, and a few public sector clients have spread their deposits. Aside from that, I would need to address the question in more detail later. Those are the trends we are currently observing.
Mike Rizvanovic, Analyst
Okay. That's helpful. Maybe we can take it offline.
Dave McKay, CEO
Thank you for the questions today. I'll summarize our performance over the last quarter and the first half of the year. A strong highlight is the performance of our core client franchises, with robust results across the board from Derek and the capital markets team as we hit our targets and experienced good client momentum, moving up to seventh in overall market share, reflecting our effective strategy. Our Canadian wealth asset management and U.S. wealth franchises continue to perform well, organically growing clients and increasing assets under administration and management at high returns on equity. Our funding remains a key advantage, and as Neil noted, we are focused on matching our funding strategies. We are gaining market share in deposits, indicating that there is significant money in motion, a trend that is global and apparent in our affluent client base. While we have healthy client franchises and are building for the medium and long term, we recognize areas for improvement in volume. We have strong capital, exceeding expectations, allowing us to pursue both organic and inorganic growth. However, we did face challenges that impacted our results. Firstly, we did not anticipate the rapid outflow of deposits into higher yield options, which began before and accelerated during the U.S. banking crisis, significantly affecting our revenue forecasts. Secondly, we were caught off guard by sudden changes in hiring markets, where aggressive hiring plans were disrupted by an unexpected halt, leading us to overshoot our staffing goals by a significant margin. This overspend has added substantial pressure to our cost structure, which rose by 8 percent. We are committed to reducing costs and have a clear plan to bring expenditures down to mid-single digits. We see strong opportunities with HSBC and Brewin Dolphin and are confident in navigating through the revenue drop and expense increases. We are determined to manage these challenges effectively and drive shareholder value. Thank you for your attendance and questions today, and we look forward to speaking with you again in three months.
Operator, Operator
Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.