Canadian Banks Look to U.S. for Growth; Profits Would Be Nice Too

TD Bank and Bank of Montreal have spent billions building up U.S. banking franchises but struggle to achieve the profit margins they earn at home.


Canadians, it’s said, move to the U.S. for one of three reasons: weather, love or money.

For two Toronto-based banks building franchises south of the border — Toronto-Dominion Bank and BMO Financial Group, parent company of Bank of Montreal — climate isn’t much of a motive. Both have targeted regions in the U.S. — the Northeast and Midwest, respectively — that don’t offer much respite from Canada’s frosty elements.

Love? Canadian banks have long found the proximity and size of the U.S. market alluring and the cultural and language similarities comforting. Even so, they often remain outsiders in terms of networking, critical mass, branding and more. Their big neighbor often seems more like an unattainable infatuation than the real deal.

Money is the primary attraction. Canada’s banks are very profitable, earning a record C$29 billion ($27.1 billion) in 2013. But their growth prospects at home are constrained by market size and saturation. They have outperformed the Canadian economy for a long time now and can’t expect to sustain that trend without some offshore help. The relatively open U.S. banking market — at $14.6 trillion in assets, about nine times the size of Canada’s — appears to offer a compelling growth opportunity.

TD Bank certainly thinks so. Over the past decade the outfit has invested $18 billion in U.S. banking acquisitions, including New Jersey–based Commerce Bancorp. Those outlays helped it build the ninth-largest commercial banking franchise in the U.S., with $215 billion in assets, just ahead of State Street Bank & Trust Co. and behind Capital One. The bank boasts more branches (1,317) along the U.S.’s Eastern Seaboard than it has in Canada (1,179). In addition, TD Bank spent a total of more than $12 billion to buy auto financing company Chrysler Financial in 2011 and to acquire the credit card portfolio of retailer Target Corp. in 2013. The group also controls 42.2 percent of online brokerage TD Ameritrade.


TD Bank got 26.4 percent of its revenue and 13.2 percent of its profits from the U.S. in 2013, according to estimates by New York investment bank Keefe, Bruyette & Woods.

In a sign of the growing importance that the U.S. franchise holds for the group, Bharat Masrani, who formerly headed TD Bank’s U.S. personal and commercial banking subsidiary, was promoted to chief operating officer last year and designated to succeed CEO Edmund Clark when he retires in November. “The U.S. market’s fundamentals are fantastic,” Masrani, 56, tells Institutional Investor. “We love the growth potential.”

BMO, which has had a foothold in the U.S. since the 1980s, recently doubled down on its bet. In 2011 it paid $4.1 billion for Marshall & Ilsley Corp., a troubled, Milwaukee-based banking company with $51.9 billion in assets. The deal nearly doubled the size of BMO’s Chicago-based subsidiary, Harris Bank, to $94 billion in assets. (It had shrunk to $90.8 billion by September 30, 2013, making it the 25th-largest bank in the U.S.)

Critics initially panned the deal as overpriced. M&I had been struggling with bad construction loans, and some analysts thought it could have been had for less than the 1.12 times tangible book value that BMO paid. The strategy and execution since the acquisition closed, which have been marked by falling customer service rankings and dwindling market share, have given the skeptics even more to complain about.

CEO William Downe, 60, a Canadian who once worked in Chicago and still owns a home there, says there’s no turning back. BMO’s U.S. operations, including capital markets and wealth management, boast 2 million customers and contribute 33 percent of the group’s total revenue and 25 percent of its net income. He expects (and needs) those numbers to increase.

“We have $27 billion of paid-in capital and a $42 billion market cap,” Downe explains. “The only way to grow that market cap is to grow customers, and the best place to do that is in the U.S. market. It’s what shareholders expect us to do.”

The push south by TD Bank and BMO has won the understanding, if not the unbridled support, of many investors and analysts. “What they’ve done well is to focus on specific regional markets and then build scale,” says Curtis Runge, a portfolio manager for Greystone Managed Investments, a Regina, Saskatchewan, money manager with C$33 billion in assets under management. The firm’s top three holdings are Royal Bank of Canada, TD Bank and Bank of Nova Scotia, known as Scotiabank.

Runge has some worries about the impact of U.S. regulators on the banks’ operations. One common concern is that the banks will effectively transform into U.S. institutions with Canadian subsidiaries, subject to the vagaries of the U.S. economic, political and regulatory environment. Nevertheless, he is generally a fan of the expansions. “They need to put their capital to work somewhere,” Runge points out. “If there aren’t opportunities available in Canada, the U.S. is a good alternative.”

Perhaps, but even if the two banks’ U.S. strategies and execution are good enough to produce strong results — and the jury is still out on that — investor returns would likely be diluted given that regulations and the operating environment there aren’t as bank-friendly as in Canada.

As things stand, the two banks’ core U.S. operations are performance laggards. In 2013, BMO Harris Bank used $14.5 billion of equity capital to generate $633 million in net income, good for a return on equity of 4.4 percent, according to SNL Financial, a Charlottesville, Virginia, firm that tracks banking industry data. The story isn’t much different at TD Bank NA. The Cherry Hill, New Jersey–based company employed $27.4 billion of equity to produce $1.6 billion in earnings, for an ROE of 5.8 percent.

TD Bank disputes those numbers. The bank measures its U.S. retail banking operations more broadly and lists only $18.9 billion in direct equity capital, describing the remaining $8.5 billion declared in its regulatory filings to be “excess capital and intercompany borrowings.” Even by the bank’s own numbers, though, TD Bank NA’s first-half ROE was just 8.3 percent, compared with an average of 9.45 percent for all U.S. banks at the end of the third quarter, according to figures from the Federal Deposit Insurance Corp.

Compared with the banks’ returns at home, those U.S. results are downright putrid. TD Bank had a 48.3 percent ROE from its domestic personal and commercial banking business in 2013; RBC’s ratio was 38.1 percent. (BMO does not break out the returns from its P&C business.)

“The core problem with TD or BMO expanding in the U.S. market is that [the investments] are significantly bringing down the overall companies’ returns on equity,” says Brian Klock, a Boston-based analyst who follows Canadian banks for KBW. “A lot of investors don’t like that.”

Critics assert that TD and BMO would do better by shareholders if they looked for investment opportunities at home or simply returned more money to their owners instead of investing it in the rough-and-tumble, low-return world of U.S. banking, where high amounts of acquisition-related goodwill are part of the package.

“If TD turned that $27 billion back into the bank and performed share buybacks, it could generate much higher rates of shareholder value,” says J. Bradley Smith, head of research for Stonecap Securities, a capital markets and research shop in Toronto, referring to the bank’s cumulative investment in the U.S. “We see some of these banks as having really violated a fundamental concept of modern-day finance, which is that it’s not sustainable to invest at rates of return that are below your cost of capital.” Smith has underperform ratings on both TD and BMO, in large part because of their U.S. exposures.

Executives at both banks preach patience. BMO’s Downe acknowledges that profits in his company’s U.S. banking business have been harder to come by than he’d like and are almost certain to hold down the group’s ROE going forward. That’s okay, he says, because the bigger objective is to expand long-term trading multiples, and the best way to do that is with earnings growth — something that is in short supply in Canada.

As growth accelerates over time, Downe says, BMO Harris will earn more than the cost of capital invested and fetch a higher multiple, making it a good deal for shareholders even if the ROE in the U.S. is nowhere near what it earns at home. He confidently predicts the bank can generate a 15 percent ROE in the U.S. over the intermediate term.

“From a shareholder perspective, if you have one group of businesses that’s earning a 20 percent return and then you double the size of the business and the increment earns 15 percent returns, well, if your cost of capital is 10 percent, then your shareholders are better off,” he says.

The trade-off between today’s profitability and tomorrow’s growth is central to any discussion of the U.S. banking operations of TD and BMO.

Canada’s so-called Big Five banks — RBC, TD Bank, Scotiabank, BMO and Canadian Imperial Bank of Commerce, by order of assets — are the bluest of the country’s corporate blue chips. All boast double-digit returns, robust share repurchase programs and dividend yields of 4 to 5 percent, making them preferred choices for Canadian investors hungry for security and yield.

The unusually high returns on the domestic banking side stem largely from Canada’s red-hot (until recently) housing market and a government-run mortgage insurance program that insulates banks from virtually any risk that home loans will default. The program, administered by the Canada Mortgage and Housing Corp., requires that all mortgagees making down payments of less than 20 percent purchase coverage.

“The bank is covered for 100 percent of the principal and interest. If there’s a default, the bank hands it off to the government for collection,” says KBW’s Klock. “The law says that the banks don’t take the risks — the government does.”

Regulators acknowledge the lack of risk by assigning a zero — yes, zero — risk weighting to insured mortgage loans for capital purposes. The banks have responded by packing their balance sheets with mortgages, which account for 58 percent of all loans at the Big Five banks. As a result, those banks all operate with tangible common-equity-to-asset ratios of less than 4 percent, about half the levels of most U.S. banks.

“These are financially engineered returns, an anomaly of the structure of the mortgage insurance,” explains Stonecap’s Smith.

No one worries too much about the Big Five being too big to fail. The banks survived the financial crisis in good shape. In 2012 the Bank for International Settlements and the World Economic Forum both declared Canada’s banks the soundest in the world.

Rating agencies broadly endorse that view. Standard & Poor’s has assigned credit ratings of A+ and AA–, respectively, to BMO and TD Bank, among the highest of any large institution in the world. By comparison, the top-rated big U.S. bank, Wells Fargo & Co., carries an A+ rating; Bank of America Corp. and Barclays are rated A–.

“You don’t get much stronger than that unless you have an explicit government relationship,” says Tom Connell, a Toronto-based analyst at S&P.

There are clouds on the Canadian horizon, though. Analysts and investors wonder where growth will come from given that the country’s economy is slowing and the Big Five already control more than 80 percent of the market.

Credit risks appear to be rising. Fitch Ratings warned in November that the Canadian housing market was overvalued by as much as 26 percent in some markets, and government agency Statistics Canada reported in December that household debt hit a record 163.7 percent of disposable income in the third quarter, roughly equal to the levels reached in the U.S. in 2008.

“We think the Canadian consumer is in a position of vulnerability,” Connell says. That could suppress loan demand and dent profits from the domestic banking business.

In contrast, the U.S. economy looks to be on the rebound. Colleen Johnston, TD Bank Group’s chief financial officer, says she frequently hears the question “Why is TD in the United States when Canadian banking has been so profitable and has been growing so well?”

Johnston explains: “The reality is that we’re going to see a slowdown in growth rates in Canada. There’s no question in my mind that going forward our U.S. earnings will be greater than our earnings from Canadian [personal and commercial] banking.”

The Big Five have long histories of chasing growth and profits overseas and using such forays as a hedge on their Canadian operations. All own foreign wealth management and/or capital markets operations, RBC most prominently. Most boast lending expertise in global niches, such as energy, mining or agriculture. Collectively, they derived 32 percent of their profits abroad in 2013, according to KBW. Scotiabank is the most global, reaping 38 percent of its profits from its Latin American banking and capital markets business and an additional 8 percent from the U.S.

“The banks are very profitable domestically. They’re generating a lot of excess capital, and there aren’t that many opportunities at home to deploy it,” says Robert Sedran, an analyst with CIBC World Markets, an arm of Canadian Imperial Bank of Commerce.So instead, “they look for sustained growth levers elsewhere that can absorb that capital going forward and provide some growth.”

Neither TD Bank nor BMO is a stranger to doing business south of the border. BMO’s capital markets operations in the U.S. earned $219 million in 2013, while its private client operations added $200 million. TD Ameritrade generated $169 million in profits over the same period.

Commercial banking is more of a struggle. Making an acquisition to build critical mass often requires banks to pay hefty premiums. Aggressive cost-cutting is usually out of the question for a foreign bank in building mode, and takeover goodwill can last a lifetime. “It’s kind of like joining a country club,” Stonecap’s Smith says. “The entrance fee creates such financial obstacles — the goodwill, the multiple you have to pay coming in, the additional capital — that it becomes prohibitively expensive.”

According to an analysis by Smith, TD’s U.S. operation ranks third among U.S. banks in the ratio of goodwill and other intangible assets to equity, at $13.8 billion, or 49 percent. BMO’s ratio is better than most at 24 percent, but that’s up from virtually nothing before the M&I deal. The banks must hold additional tier-1 common equity to offset the goodwill dollar for dollar, reducing their ROE.

TD and BMO, as well as their investors, need look no further than RBC for a cautionary tale of how even the best-laid plans for U.S. expansion can go awry. In the early 2000s the Canadian flag carrier spent $6.3 billion piecing together a 424-branch, $25 billion-in-assets U.S. commercial banking franchise. RBC Bank, as the U.S. subsidiary was called, lost market share and took a $1 billion write-down on bad housing loans in 2009 before its parent cut its losses and sold the unit to Pittsburgh-based PNC Financial Services Group for $3.45 billion in 2011.

That experience dealt a blow to Canadian confidence. “You were reminded that even your best aren’t infallible,” analyst Sedran says. “It’s made people more skeptical of international expansion generally with Canadian banks, and frankly it’s made it a lot harder for TD and BMO to win the hearts and minds of investors when it comes to their U.S. strategies.”

The market’s tendency to view the two banks’ U.S. franchises in the same light — and in the shadow of RBC’s retreat — doesn’t do either any favors but might hurt perceptions of TD Bank more, says Cheryl Pate, a banking analyst with Morgan Stanley. She maintains an overweight rating on TD stock, with a C$105 price target (it closed at C$97.60 in mid-January), but an underweight on BMO, with a C$70 target (it closed at C$71.74). The U.S. outlook for each bank is a major reason for the divergence.

“What TD has been doing in the U.S. has been very successful of late,” Pate explains. “Loan growth is ramping up on both the consumer and commercial lending sides. It’s been a slower trajectory for BMO. They’ve achieved some cost saves [from the M&I merger], but it’s been more difficult for them to show top-line growth.”

TD Bank made its first significant foray south of the border in 2005, paying $3.8 billion for a 51 percent stake in Portland, Maine–based Banknorth Group, a $29 billion-in-assets bank with nearly 400 branches. “The physical proximity, cultural affinity and common language made a lot of sense to us,” says CFO Johnston.

Two years later TD acquired the rest of Banknorth. Then in 2008 it went all-in on its U.S. strategy by paying $9 billion for Commerce, the $51 billion-in-assets outfit founded by Vernon Hill.

The integration hasn’t been without challenges. Hill believed banking success comes from deposit relationships more than from loans, and he spent freely on people, facilities and advertising to win customers. TD’s early efforts to squeeze more profits backfired, causing a significant erosion of the franchise. The Canadian bank had difficulties in converting Commerce customers to its systems, leading to delays in the postings of everything from mortgage payments to Social Security deposits, and it raised charges for overdraft protection and other services. Between 2005 and 2009 only about one quarter of TD Bank’s U.S. branches gained market share and more than half lost share, according to an analysis by Stonecap’s Smith based on FDIC figures.

Jay Sidhu, who competed against Commerce as chairman and CEO of Sovereign Bancorp until 2006 and today runs Customers Bancorp, a $3.9 billion-in-assets lender based in Wyomissing, Pennsylvania, says the strategic shift was jarring. “Commerce’s goal was to attract customers. They didn’t worry about how much money they made. TD wants to attract customers and make money. The strategy is better financially, but it’s been bad for their image,” Sidhu says, adding that he has hired away several TD bankers — something that “never happened in the Commerce days.”

The effects of Hill’s deposit-focused strategy are still evident today: TD Bank’s U.S. loan-to-deposit ratio stands at 55 percent, compared with ratios of 80 percent-plus at most large competitors, such as Bank of America and PNC. “If you look at our balance sheet, we’re probably the most liquid bank in the world,” COO Masrani concedes.

The bank’s recent acquisitions were aimed at putting that funding to work. In 2011 the company paid $6.4 billion for Chrysler Financial, a leading U.S. auto financing firm. In 2013 it closed on the purchase of retailer Target’s $5.8 billion credit card portfolio, a deal that comes with exclusive rights to issue Target-branded Visa and private-label credit cards for seven years. (The recent disclosure that hackers stole credit and debit card information on as many as 110 million Target customers “will undoubtedly have an impact” on TD Bank’s earnings for a quarter or two, but not a lasting one, says CIBC’s Sedran.)

Takeovers are only part of TD’s story. Masrani contends that what sets the company apart from the competition is its aggressive green-field expansion into Manhattan and other East Coast markets, including Boston and Florida, at a time when many banks are scaling back their physical presences. Using the tagline “America’s most convenient bank,” TD opened 41 branches in 2012 and an additional 24 last year, many of them at high-traffic intersections populated by other banks. “Our model works particularly well when we have a lot of competition around us,” Masrani says.

Such efforts appear to be working. Between 2009 and 2012, 59 percent of TD’s U.S. branches showed deposit gains, compared with 41 percent for the industry as a whole, according to Stonecap’s Smith.

Revenue jumped 16 percent in 2013, to $7 billion, and earnings adjusted for litigation expenses and other exceptional items advanced 12.6 percent, to $1.5 billion. Loans, excluding the Target card business, grew 13 percent, and deposits rose 10 percent. “We’re a young franchise in the U.S.,” CFO Johnston says. “We have a tremendous amount of room to grow.”

Largely on the strength of the U.S. performance, eight of ten analysts tracked by SNL Financial now rate TD shares as outperform or a strong buy, with a mean 12-month target price of C$104.50.

“You’re seeing both earnings and asset growth in the U.S.,” says analyst Sedran, who projects that TD Bank Group’s earnings per share will grow 13 percent in 2014, to C$8.44. “There’s evidence that over the longer term TD’s strategy is working,” he adds.

BMO has more of a tussle on its hands. It has owned Harris, Chicago’s No. 2 bank by deposits behind JPMorgan Chase & Co., for nearly 30 years, but the business has never been a particularly strong performer. Harris lost money in 2009 and broke even a year later. The unit didn’t suffer any dramatic losses during the crisis and did not take any bailout money from the U.S. Treasury’s Troubled Asset Relief Program.

Paul O’Connor, head of Angkor Strategic Advisors, a Chicago bank consulting firm, says Harris has consistently failed to live up to the promise of its franchise in Chicago. “If you took one arm and crossed it over the other, that’s their strategy,” he says. “The greatest gift any bank can receive is to have Harris buy the bank next door.”

That’s pretty much what happened to a lot of Midwestern banks when BMO expanded its franchise by buying M&I. The relatively rich $4.1 billion price tag surprised many observers, considering M&I’s troubled property development loans in the Southwest. BMO later paid an additional $1.7 billion to facilitate M&I’s exit from TARP, bringing the effective price to about $5.8 billion.

Today, BMO Harris has 686 branches, concentrated mostly in the Midwest, including new, large presences in Milwaukee and Minnesota’s Twin Cities. CEO Downe’s strategy is for BMO Harris to be the point bank in a “Great Lakes economy” that straddles the border and is driven by trade.

Mark Furlong, 55, the former M&I chief executive who was named BMO Harris’s CEO at the time of the acquisition, touts this bank’s ability to leverage BMO’s scale — in terms of technology efficiencies as well as product and service offerings — as a key advantage. He tells of a corporate client in Wisconsin that recently employed BMO’s investment banking services. “Every time M&I needed someone to do a foreign exchange derivative or interest rate swap, we had to expose the customer to a competitor,” Furlong explains. “Now we have those resources in-house. There isn’t any aspect of our business that we think we can’t grow. We’re not at capacity anywhere.”

To date, the integration of M&I into Harris has been mostly a cost reduction story. BMO claims to have achieved more than $400 million in savings by combining back-office systems and operating the company as one North American operation.

Holding on to employees and customers has been more of a challenge. Frustrations over how the centralized technology platform affects customers have led some lending officers to leave. Customers have followed. A study released in April 2013 by J.D. Power & Associates ranked BMO Harris second to last among Midwestern banks in retail customer satisfaction. Before the deal Harris regularly ranked in the top half of the survey. BMO’s internal tests also have shown declines. “You expect some of that when you’re going through an integration,” Furlong says. “Now we’re on a recovery.”

BMO Harris has seen its deposit market share in M&I’s old home base of Milwaukee drop from 22.6 percent in 2011 to 16.3 percent in June 2013, according to the FDIC. In Minneapolis market share declined to 1.88 percent from 2.4 percent.

Morgan Stanley’s Pate says the Midwest is more competitive than the East Coast for TD Bank and that BMO’s U.S. mortgage book has shrunk as the company has sold more home loans on the secondary market rather than retaining them. Other targets for loan growth are traditional commercial and industrial lending and auto finance, both tough areas to crack with anything other than pricing. BMO has scored some impressive gains. C&I loans jumped by $3.9 billion, or 17 percent, in the third quarter from a year earlier. But overall, loans have been flat, and the net interest margin fell to 4.07 percent in 2013 from 4.4 percent a year earlier. Revenue declined 5 percent over the year, to $2.87 billion, while net income adjusted for acquisition-related costs slipped 1 percent, to $633 million, despite a $100 million reduction in expenses.

“We think it’s going to be difficult for BMO to show top-line growth going forward, particularly when you look at the flat-to-declining market shares outside of Chicago,” Pate says.

The key may simply lie in riding out the integration of M&I and hoping for a rebound. But sooner or later both companies must answer the question: Can they find the kind of organic growth stateside that will fetch U.S.-style multiples, a couple of ticks higher than those of Canadian banks? (In mid-January, BMO was trading at 11.3 times 2014 consensus earnings estimates and TD at 11.8 times, both below the 13.2 multiple for the 25 U.S. institutions in KBW’s bank index.) Or will they resort to more acquisitions?

Rumors persist that TD will make a bid for Providence, Rhode Island–based RBS Citizens Financial Group, a $126 billion-in-assets banking company owned by troubled Royal Bank of Scotland Group. RBS recently sold Citizens’ Chicago branches to U.S. Bancorp; it plans to spin off its remaining U.S. operations, which have a Northeastern footprint that would mesh well with TD’s network, in an IPO by 2015.

COO Masrani dismisses the suggestion that TD Bank could bid for Citizens, insisting that any acquisition deal must be small and “fit our strategy and accelerate our organic growth.” Skeptics, including KBW’s Klock, note that a Citizens purchase would likely require TD to issue more equity and could exacerbate the group’s goodwill issues.

BMO has been mentioned as a potential suitor for TCF Financial Corp., an $18 billion, Wayzata, Minnesota, bank that has strong branch networks in Chicago and Detroit. CEO Downe won’t get into specifics but says BMO will “look at in-fills and do some small acquisitions. Within our footprint we have plenty of opportunities to increase our concentration.”

One thing appears certain: If and when the next big deal in the States comes, it will take another bite out of the banks’ ROEs, a trade-off for growth that both management teams have shown they think is worth it.

“We have an obligation to hand off TD to the next generation with a growth platform,” Masrani says. “We’re thinking decades in advance. We can’t continue to outgrow Canada. We need to expand.” • •