Royal Bank of Canada Is Managing Difficult Economic Conditions Well; Shares Roughly Fairly Valued

Equity Analyst

Michael Miller

Royal Bank of Canada is one of the two largest banks in Canada by assets and one of six that collectively hold roughly 90% of the nation's banking deposits. The bank derives two thirds of its revenue from Canada, with the rest primarily coming from the United States. It has done an admirable job of expanding its nonbank lines of business, running efficient banking operations, and generating some of the best returns for shareholders in the industry. We believe RBC should remain one of the dominant Canadian banks for years to come, even as a more difficult macro backdrop pressures earnings growth in the medium term.

We expect Royal Bank of Canada to remain a steady player in its retail and commercial Canadian banking operations. It also remains a major player in global capital markets. We expect this segment to continue to be a strong contributor to net income, and if anything, capital markets have been countercyclical for the bank during the pandemic as earnings have soared for the unit. 

The wealth-management segment also earns strong returns on equity, and large inflows have led to a top market position. RBC remains a top asset manager and gatherer in Canada, and is also experiencing outsize growth from City National, where cross-selling and client integration efforts have gone well. The banks’ distribution networks are arguably the most dominant in Canada, and the bank has the largest amount of assets under management among the Canadian banks.

We like RBC's growth strategy in the U.S. through City National, focusing on wealth and commercial clients. We believe this is a much more focused strategy than its previous attempts at growth in the U.S., and it is paying dividends. While exposure to the U.S. isn't as great right now given some of the industry turmoil, deposit and earnings pressure has been manageable.

We are relatively neutral on RBC's acquisition of HSBC Canada. It is a decent franchise with a decent client base and will allow RBC to gain some incremental share in Canada, however, we believe client retention risks, the price paid, and regulatory risks make this a roughly neutral move.

Business Strategy & Outlook

With superior operating efficiency, leading share in the Canadian banking market, moaty nonbank businesses, and the ability to primarily operate in the favorable Canadian banking environment, Royal Bank of Canada is worthy of a Wide Morningstar Economic Moat Rating, in our view.

We believe bank moats are derived primarily from two sources: cost advantages and switching costs. We see switching costs in the Canadian system being driven by a tightly regulated oligopolistic market structure, which limits excess competition, therefore stabilizing product pricing and giving customers less incentive to switch banks. We see cost advantages as stemming from three primary factors: a low-cost deposit base, excellent operating efficiency, and conservative underwriting. Regulatory costs must also be considered. We view the Canadian banking environment as offering systemic cost advantages for the banks under its domain. These advantages manifest themselves in the form of lower operating costs, lower credit costs, lower regulatory costs, and lower absolute levels of and better diversification of risks, all of which allow the banks to achieve greater risk-adjusted returns.

In our view, Royal Bank of Canada has a wide moat because it has superior market share in the advantageous Canadian banking environment, superior operating efficiency, and exposure to more moaty nonbank businesses. The bank has consistently operated with one of the best efficiency ratios in Canada, partially through superior operational execution, and partially due to the highest noninterest income proportion among the Canadian banks. The bank is also one of the two largest banks in Canada (along with Toronto Dominion) and has dominant market share in many categories, including number-one or number-two share in all key retail banking products. It is also one of the dominant investment banks in Canada and a top-15 player worldwide. Once you reach the scale and reputation required to source and execute deals, offerings, and advice that Royal Bank of Canada has, we believe the investment banking business becomes moatier. It also has the largest amount of assets under management and assets under administration among the Canadian banks, giving it the largest exposure to this higher-margin, fee-based business, and a larger share of clients’ overall wealth. 

We believe the Canadian banking environment offers systemic cost advantages that lead to returns above the cost of capital, allowing the main banks operating under its jurisdiction to possess moats. 

Barriers to entry are very high for the Canadian banking system. Existing regulations prevent foreign competition, as non-Canadian residents may not own more than 25% of the shares of a bank unless approved by the government (preventing foreign takeover), and foreign banks can only operate in Canada under certain restrictions (preventing significant direct foreign competition). Domestic competition is also controlled, as Canada’s banking system historically developed to favor a few large banks controlling the majority of the domestic market, and this is actively enforced through the handling of chartering by the federal government exclusively. Additionally, the rejection of merger proposals in 1998—between Royal Bank of Canada and BMO, and between Toronto Dominion and Canadian Imperial Bank of Commerce—created a precedent where no further consolidation between the main Canadian banks will be accepted by the regulators. 

Having larger banks helps to spread out fixed costs across a larger operating base, increasing operating efficiency, as the four largest Canadian banks are all bigger than the largest U.S. regional bank. The Canadian banks, because their branch networks spread out through all of Canada, arguably have some of the most powerful distribution networks in Canada. This offers cost advantages via lower customer acquisition costs. In addition, the banks are involved in nearly every major financial product, including asset management, wealth management, insurance, investment banking, and a variety of other consumer and commercial banking products and services. Bigger scale, powerful distribution networks, a multitude of products, and diversification of business lines lead to economies of scope in addition to the economies of scale already achieved.

We believe a more protective and efficient regulatory system also leads to cost advantages, primarily through risk reduction. Less fragmented and well-integrated banking systems, like the Canadian system, have tended to be more stable over time, reducing risk. Also, the Canadian regulators must only primarily monitor and develop relationships with the big six Canadian banks, which is much easier than trying to monitor the thousands of banks that exist in the U.S., for example. This leads to more collaboration and cooperation between regulators and banks, as well as greater institutional memory and more coordinated and easily implemented responses if strains begin to appear in the system. Regulators also help to control pricing in the market at times, such as on mortgage products, helping to reduce the potential for pricing wars to gain market share at the expense of underwriting standards. Canadian regulation also makes it more difficult for bad credit to be issued in many ways, including mandatory insurance and standards on riskier mortgage loans, not having a GSE-like government-subsidized mortgage securitization market, and forcing banks to hold more of the risk on their own balance sheets. These factors help contribute to better absolute risk reduction in the system as well as regulatory economies of scale.

The Canadian banks are also more geographically diversified on average than, for example, the majority of U.S. regional banks, which often have concentrations in individual states or local economies. This diversifies credit risk, lowering the overall risk for each individual bank. Canada’s system of higher taxes, more social safety nets, and other complex factors have also led to a more robust and stable middle class that contributes to economic and political stability, further reducing systemic risk.

Combine all of these factors, along with explicit government subsidies on deposit insurance and mortgage insurance, as well as the implicit subsidy of being too big to fail domestically (all big six Canadian banks are labeled as domestic systemically important banks at a minimum), and we believe an environment exists where excess returns for banks are almost certain to exist in Canada.

Wide

Economic Moat

Royal Bank of Canada

City National Bank is an American financial institution headquartered in the City National Plaza in Los Angeles, California. It has been a wholly owned subsidiary of the Royal Bank of Canada since 2015. It offers a full complement of banking, trust and investment services through 75 offices, including 16 full-service regional centers, in Southern California, the San Francisco Bay Area, Nevada, New York City, Minneapolis, Nashville, Washington, DC and Atlanta with a total of $35.6 billion in total assets.

City National Bank

Royal Bank of Canada engages in the provision of banking and financial services. It operates through the following segments: Personal and Commercial Banking, Wealth Management, Insurance, Capital Markets, and Corporate Support. The Personal and Commercial Banking segment deals with a broad suite of financial products and services in both individual and business clients in Canada, the Caribbean, and the U.S. The Wealth Management segment offers a suite of wealth, investment, trust, banking, credit, and other advice-based solutions. It also offers other wealth management solutions to institutional and individual clients through its distribution channels and third-party distributors. The Insurance segment refers to a suite of advice and solutions for individual and business clients including life, health, wealth, property and casualty, travel, group benefits, annuities, and reinsurance. The Capital Markets segment is involved in the provision of advisory and origination, sales and trading, lending and financing and transaction banking to corporations, institutional clients, asset managers, private equity firms and governments globally. The Corporate Support segment consists of technology and operations services. The company was founded by J. W. Merkell, Edward Kenny, T. C. Kinnear, James B. Duffus, William Cunard, John Tobin, George P. Mitchell and Jeremiah Northup in 1864 and is headquartered in Toronto, Canada.

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