Bank of Montreal

NYSE:BMO

Earnings Call Transcript 2019-Q2

[Operator]

Please be advised that this conference call is being recorded. Good morning, and welcome to the BMO Financial Group's Q2 2019 Earnings Release and Conference Call for May 29, 2019. Your host for today is Ms. Jill Homenuk, Head of Investor Relations. Ms. Homenuk, please go ahead.

[Jill Homenuk, Head of Investor Relations]

Thank you. Good morning, everyone, and thanks for joining us today. Our agenda for today's investor presentation is as follows. We will begin the call with remarks from Darryl White, BMO's CEO; followed by presentations from Tom Flynn, the bank's Chief Financial Officer; and Pat Cronin, our Chief Risk Officer. We have with us today Cam Fowler from Canadian P&C; and Dave Casper from U.S. P&C. Dan Barclay is here for BMO Capital Markets; and Joanna Rotenberg is here for BMO Wealth Management.After their presentations, we will have a question-and-answer period where we will take questions from prequalified analysts. To give everyone an opportunity to participate, please keep it to 1 or 2 questions.On behalf of those speaking today, I note that forward-looking statements may be made during this call. Actual results could differ materially from forecasts, projections or conclusions in these statements. I would also remind listeners that the bank uses non-GAAP financial measures to arrive at adjusted results to assess and measure performance by business and the overall bank. Management assesses performance on a reported and adjusted basis and considers both to be useful in assessing underlying business performance. Darryl and Tom will be referring to adjusted results in their remarks unless otherwise noted as reported. Additional information on adjusting item, the bank's reported results and factors and assumptions related to forward-looking information can be found in our 2018 annual report and our second quarter 2019 report to shareholders.With that said, I will hand things over to Darryl.

[William Darryl White, CEO & Director]

Thank you, Jill, and good morning, everyone. Today, we announced strong performance for the second quarter with earnings of $1.5 billion and earnings per share of $2.30, an increase of 5% over last year, and this is after absorbing a severance cost in our capital market's pillar. This follows good first quarter results with steady performance in an improved market environment. And for the first half of the year, earnings per share are up 7%, in line with our midterm target range, and we believe we are on track to deliver that same level of growth in the second half of the year as well. This quarter was highlighted by solid momentum across our businesses supported by stable economic fundamentals.Looking back, as we headed into fiscal 2018, so 6 quarters ago, we highlighted key areas of strategic focus where we planned to accelerate our performance: growth in our U.S. segment; improved efficiency; transformation of our business through innovation; and the importance of our people and culture.At our Investor Day in the fall, we reiterated these strategies and we formalized specific targets for the bank and our operating groups, including achieving 1/3 of our earnings from the United States. We've consistently said that we were confident in the outlook of our businesses in the United States, and we're working to grow earnings from our U.S. segment faster than the overall bank. We highlighted our progress in distinctive areas of strength at the bank's AGM in April.At the beginning of 2008, our U.S. segment contributed about 25% of total bank earnings. After several consecutive quarters of strong performance, that contribution has grown to 35% of the bank's earnings so far this year.More broadly, our operating groups are progressing against their strategies. Canadian and U.S. P&C are delivering good results, reflecting strong and diverse loan and deposit growth. Capital Markets and Wealth Management had good operating performance in the quarter in a more constructive market environment.We're committed to our efficiency target of 58% by 2021. And at the same time, we're taking disciplined actions to execute against our strategy and position the bank for sustainable growth over the long term. For example, we've made organizational changes within our Capital Markets group to align resources with the revenue environment, which impacted operating leverage in the current quarter and will deliver improved efficiency going forward.Our results this quarter include a severance cost, which we absorbed in our Capital Markets group of $120 million pretax negatively impacting our adjusted earnings by $0.14 per share.Our capital position remained strong and is supporting robust organic growth across our businesses, which as we've said, is our top priority. ROE in the quarter was 13.9%, and we announced the $0.03 increase to our quarterly dividend or 7% over last year.Turning to Slide 5. As I mentioned earlier, we're continuing to drive positive momentum from our U.S. platform, which remains a clear differentiator for BMO. Year-to-date earnings were up 29% driven by strong growth in U.S. P&C and Capital Markets with pre-provision, pre-tax earnings growth of 20%, positive operating leverage and improved efficiency.We delivered another consecutive quarter of industry-leading commercial loan growth, which continues to be high quality and well diversified across industries and geographies.As I look across the bank, we're building on our strong foundation and differentiating strengths to grow our businesses and deepen customer loyalty. For example, in North American commercial banking, our deep sector expertise and collaborative approach to building customer relationships differentiates us in the market, including in the technology sector. This quarter, we introduced a specialized technology and innovation banking group that provides tailored advice and funding to this important industry as well as integrated cross-border, Capital Markets and Wealth Management solutions. These companies are critical to driving innovation and positive change in Canada and we're uniquely positioned to help them grow and compete through every stage of their life cycle.Wealth Management has an advantage position in the market, including in the ETF market where we were ranked #1 in Canada for net new asset growth for the eighth consecutive year as well as having leading loan and deposit growth. To further support our strong performance, we're taking actions to grow our position with clients, including bringing together our full-service brokerage and private banking businesses to deliver best-in-class advice to serve clients' increasingly complex needs. The coming together of Asset and Wealth Management under one group head, along with new leadership in BMO Asset Management, positions the wealth business for continued global growth building on its strategic advantages.In Capital Markets, our client-driven strategy is clear and unchanged and is delivering good year-to-date operating performance. Investment in corporate banking revenue is up 18% compared to the first half of last year. Our acquisition and successful integration of KGS is performing ahead of expectations, and the U.S. businesses contributing over 1/3 of Capital Markets' earnings compared to less than 25% at this time last year.So across the company, we've been making targeted investments in technology that drive customer experience and revenue. As an example, in treasury and payment solutions, we're partnering with Mastercard Send to enable faster cross-border payments for our Canadian clients. For our U.S. customers, we've teamed up Zelle to offer quick and easy business to customer payments. In U.S. personal and business banking, customers are embracing our new digital capabilities. Since launching our digital account opening platform, we've seen significant increases in digital checking account applications primarily by our mobile devices, which is contributing to our very strong deposit growth.Our effective use of technology to enable business success, including our agile and collaborative approach to innovation was recognized this quarter with 2 Celent 2019 Model Bank Awards. Collaboration is but one aspect of our distinctive culture as is our commitment to doing what's right and leveraging our role as a trusted financial advisor to create opportunities for lasting positive change in the world. Consistent with our strong support of gender balance and the advancement of women, I'm proud that BMO is the first Canadian bank to sign the UN and Women's Empowerment Principles, which provides a global framework to promote gender equality and empower women in the workplace, marketplace and community.Looking ahead, we remain confident about the resiliency of the Canadian and U.S. economies supported by population growth, low unemployment, modest inflation and stable interest rates. We have good momentum across our businesses that will drive performance in the second half of the year similar to the first. And the investments we've made position us well for long-term success.Now at this point, I'll turn it over to Tom to talk about the second quarter financial results.

[Thomas E. Flynn, Chief Financial Officer]

Thank you, Darryl, and good morning, everyone. My comments will start on Slide 8.Q2 reported EPS was $2.26, and net income was $1.5 billion. Adjusted EPS was $2.30, up 5% and adjusted net income was $1.5 billion, up 4%. Results this quarter reflect continued good performance in our U.S. segment, strong commercial loan growth on both sides of the border and a stable operating environment. Adjusting items are similar in character to past quarters and are shown on Slide 24.Net revenue of $5.7 billion was up 8% or 6% excluding the stronger U.S. dollar with growth across all operating businesses. Expenses increased 10% or 9% excluding the impact of the stronger U.S. dollar. The BMO Capital Markets severance expense of $120 million pretax and the acquisition of KGS accounted for 5% of the expense increase. The remaining 4% was mainly driven by a higher technology and employee-related costs.Year-to-date, expense growth was 7.3% all in. And looking forward for the second half of the year, we expect expense growth to be approximately half of that rate. Operating leverage for the quarter was negative given the impact of the severance expense and above 1% excluding it.Moving to Slide 9 for capital. The Common Equity Tier 1 ratio was 11.3%, down 10 basis points from the first quarter. As shown on the slide, the ratio declined as retained earnings growth was more than offset by higher risk-weighted assets. The higher risk-weighted assets were driven by very strong commercial and corporate loan growth across our businesses, which is a reflection of our strength in this area.Moving to our operating groups and starting on Slide 10. Canadian P&C net income was $615 million, up 5% from last year. Revenue growth was 5% driven by higher balances across most products, increased noninterest revenue and higher margins.Total loans were up 6%, with commercial loans up 15%. Mortgage growth through proprietary channels, including amortizing HELOCs was good at 4%. We also had strong deposit growth, with personal balances up 9% and commercial up 7%.NIM was flat compared to the first quarter and up 2 basis points from last year. Expense growth was 5% reflecting investment in the business, and the operating leverage was positive. The provision for credit losses was $138 million and includes a $16 million provision for performing loans.Moving to U.S. P&C on Slide 11, and my comments here will speak to the U.S. dollar performance. Net income for the quarter was $314 million, up 12% from last year. Revenue growth was 5%, reflecting higher deposit revenue and loan volumes net of loan spread compression. Average loan growth was 12%, with commercial loans up 15% and higher personal loan volumes. With strong deposit growth of 13%, Q2 marked our third consecutive quarter of double-digit growth in both personal and commercial deposits.Net interest margin was down 10 basis points from last quarter, 3 basis points of the decline was due to lower interest recoveries in the current quarter. The majority of the balance is attributable to loans growing faster than deposits and tighter spreads in commercial lending.Expenses were up 6% from a below-trend level last year primarily due to higher employee and technology-related expenses. Year-to-date, operating leverage is strong at 2.6% and expenses are up 4%. Provisions for credit losses were low this quarter, largely reflecting a recovery in commercial loans and stable credit conditions.Turning to Slide 12. BMO Capital Markets net income was $253 million. Strong performance in investment and corporate banking and good results in the U.S. segment were offset by the impact of severance expense. The U.S. business net income was up 24% reflecting good diversified performance across both investment and corporate banking and trading products, including the benefit of the KGS acquisition partially offset by the severance expense.Revenue was $1.2 billion and up 18% or 17% excluding the impact of the stronger U.S. dollar. Investment in corporate banking revenue increased 21%, reflecting loan growth and higher debt in equity underwriting. Trading products revenue was up 16% with fair value adjustments contributing to above-trend interest rate trading and lower equity trading revenue.We had good client activity in interest rate and commodity trading and slower equity trading activity. Expenses were up 31% or 29% excluding the impact of the stronger U.S. dollar with 18% of that growth due to severance expense. The severance expense together with the impact of the KGS acquisition accounted for over 24% of the year-over-year increase in expenses. Provisions for credit losses were $15 million compared to a recovery of $13 million in the prior year.Moving now to Slide 13. Wealth Management net income was $315 million, up 3% from prior year. Traditional wealth net income of $236 million was relatively unchanged from last year as strong net interest income and the benefit of improved equity markets was largely offset by expenses and lower performance fees in asset management from a high level last year.Average loans are up 16%, the fifth conservative quarter of double-digit growth and deposits were up 4%. Insurance net income was $79 million, up 14%, largely reflecting a benefit from market movements in the current quarter relative to unfavorable movements in the prior year.Expenses were well managed, up 2% from last year. Assets under management and administration were up 4% driven by stronger equity markets and foreign exchange.Turning now to Slide 14. For Corporate Services, the net loss was $78 million, unchanged compared to last year as lower expenses were offset by lower recoveries for credit losses.And to conclude, the second quarter results reflect continued good momentum across our businesses. Operating groups are well positioned for the opportunities in the environment and are focused on the execution of our strategies.And with that, I'll hand it over to Pat.

[Patrick Cronin, Chief Risk Officer]

Thank you, Tom, and good morning, everyone. So starting on Slide 16. The total provision for credit losses this quarter was $176 million or 16 basis points, which is up from 13 basis points last quarter.Our PCL on impaired loans increased to $23 million to $150 million or 14 basis points this quarter, while our PCL on performing loans was $26 million compared to $10 million last quarter. Of note, this quarter had a large U.S. commercial recovery, absent which the total PCL would have been 20 basis points, which is in line with the recent guidance and our ongoing expectations.Now turning to each of the businesses. In the consumer segment of Canadian P&C, PCL and impaired loans was up marginally quarter-over-quarter. And in the Canadian commercial segment, our impaired provisions were $15 million, increasing from a low level last quarter. PCL on impaired loans for U.S. P&C increased slightly by $3 million to $18 million. Now last quarter, you may recall, was characterized by a large consumer recovery related to an insurance settlement while this quarter includes a similarly sized commercial recovery. As a result of these 2 items, U.S. consumer provisions are up quarter-over-quarter while U.S. commercial provisions are down. Excluding the recovery, U.S. P&C provisions on impaired loans are broadly in line with recent experience and expectations.PCL on impaired loans for Capital Markets was $12 million compared to a $1 million provision in Q1. Variation in Capital Markets PCL is expected for this portfolio given its size and the nature of the exposures. The $26 million provision on performing loans in the quarter was primarily due to portfolio growth with small increases attributable to modest credit quality movements and some modest changes in our macroeconomic outlook.Now turning to Slide 17. Formations increased quarter-over-quarter as business and government formations were higher across a handful of industries, including oil and gas. Within that segment, the majority of formations related to 2 accounts on which we do not expect to take provisions. Formations on the other industries were related to company-specific events, reflecting normal variability in our corporate commercial portfolio and with no underlying sectoral trends.Consumer formations increased largely in Canadian residential mortgages as a result of the implementation of a new collections platform in the quarter. Looking out over the next few quarters, we expect loss rates will continue to be low in this segment.The ratio of gross impaired loans to total loans was 53 basis points this quarter, which while increased slightly from last quarter, is 3 basis points lower compared to the prior year.The second quarter continued the recent trend of strong wholesale loan growth. Similar to prior quarters, the growth remains broad-based across industries, is from both existing and new clients, and is of a credit quality that is consistent with the broader portfolio.In summary, our PCL results this quarter, adjusting for the large commercial recovery, were in line with our experience over the past few years and our expectations. Our guidance for PCL over the longer term has not changed.I will now turn the call over to the operator for the question-and-answer portion of today's presentation.

[Operator]

[Operator Instructions] The first question is Ebrahim Poonawala with BoA Merrill Lynch.

[Ebrahim Huseini Poonawala, Director]

I guess to start out, if you could touch on commercial loan growth both in Canada and the U.S., very strong both year-over-year and quarter-over-quarter. If you could just -- I know you mentioned it was broad-based, but would appreciate if you can talk about some of the drivers is this growth coming from particular industries and just the pricing environment for the business. And also what the sensitivity would be if the macro deteriorates, like, do you still expect this double-digit growth to continue in the back half the degree of confidence?

[Cameron Fowler]

Thanks for the question. It's Cam Fowler speaking. I'll start with the Canadian commercial loan growth and I'll pass to Dave Casper to talk about the U.S. The first thing I'd say is, it is strong growth, it's not a surprise to us. I've mentioned in the last several calls and indeed at our Investor Day that we've been investing in both capacity and the commercial business as well as diversification. And you can see in our next line, our revenue line and our balance line, the investment we've made on the commercial business, which is 150 new relationship managers. The growth is of a higher -- of a very high quality, I guess, is what I would say. We're particularly pleased with the diversification. I think no fewer of 7 or no fewer than 7 or 8 sectors that are growing in the double-digit range, and it's particularly well distributed across the country and that all regions are also participating at that level. And there is no particular sector within that, that I would point to that is outsized or growing beyond what the average of the book is. And so I would start with that quality point. You made a question about the outlook. Our quarter-on-quarter number is relatively strong. I wouldn't expect that 5% quarter-on-quarter number to maintain necessarily, so some degree of moderation perhaps. But for now, from a capacity and diversification perspective, we feel very confident in the book. Dave?

[David Robert Casper, Chairman & CEO]

So it's Dave. Just picking up on where Cam left off. We had a real strong quarter, and it's consistently been very strong over the last 5 or 6 years as we try to grow out our commercial business in U.S. Two points: number one, it's growing both geographically to a broader base; secondly, it's growing across all of our specialized sectors. The other thing I would point out is and really to Cam's point, too, this was an exceptionally good quarter. We have forecasted and said in the past that we would expect 2 things: our growth would be outside and better than our competitors, our peer competitors; and secondly would probably be in the high 9%, 10% is really what we had said. So this was better than we expected. Same comment on quality. And maybe Pat, wants to add something or maybe not as well.

[Patrick Cronin, Chief Risk Officer]

Yes. Thanks, Dave. And then from a risk perspective, we would look at the growth rate obviously as being high. But we see it really much more of a -- as a function of the supply of good risk-adjusted opportunities. If you compare the 22% growth you would have seen year-over-year in wholesale with the similar period in the year before, that growth rate was more like 2%. So it really ebbs and flows based on where we see good opportunities from a risk-reward perspective. I would agree with both Cam and Dave, we see it as being very well diversified by sector, by geography. It's about a 50-50 split between new and existing clients. So what you would hope to see. Our credit quality is definitely strong. We look at both the overall probability of default of the existing portfolio, which has actually been getting better over time as well as the weighted-average probabilities of default of the growth that we're seeing over period. And that we see as actually being better than the quality of the overall book. So the quality from a credit perspective is actually quite strong. I can tell you our risk appetite has not changed, nor have our lending standards and practices. So this -- our processes are exactly the same as they have been and have served us well for many years. And not surprisingly, being a strong commercial bank, we think we've got really strong expertise in risk management both in the first and second line. And so as long as the opportunities for good risk-adjusted returns are there, we remain comfortable with the growth rates.

[Ebrahim Huseini Poonawala, Director]

That's helpful. And just separately one quick question for Tom on capital. Just looking at the risk-weighted asset inflation this quarter, is it -- can you talk about just expectations around organic capital generation going forward? And my sense is the more growth come from commercial, the U.S., it is going to use up -- see more RWA inflation. So any color on that would be helpful.

[Thomas E. Flynn, Chief Financial Officer]

Yes. Thanks for the question. So as the group has talked about we feel very good about the growth that we've got in our commercial businesses and our corporate businesses. And we think deploying capital in those areas is the best place that we can deploy the capital. With the strong growth, the ratio was down a little bit in the quarter. And looking forward, we do expect growth to remain good in the U.S. in particular above market, as Dave said. But 15% commercial, both in Canada and the U.S. is a high number. And so we think that will move down a little bit over time, although remaining strong. And with that, that will help with producing some accretion to the capital ratio. So our normal guidance is to expect the ratio to be up 10 to 15 basis points a quarter. Over the next quarter or 2, we're likely in the lower end of that range with the ability because there's a little bit of randomness to the calculation for the number to move around. And then as we move into next year, we expect to be back to the normal guidance of 10 to 15 basis points.

[Ebrahim Huseini Poonawala, Director]

And remind us, Tom, should we expect capital ratios to build? Are you okay with seeing the CET1 drift higher? Or what's the level of that which you want to operate the bank and maybe could see it over the next year or 2?

[Thomas E. Flynn, Chief Financial Officer]

So I would say we're very comfortable with the ratio itself. The ratio is strong. We've got lots of capital. And we feel good about that. And then in terms of where we'll operate, it's likely in the range of, give or take, 11% to 11.5%. And so the ratio could drift up a little bit. But as it did that, as you've seen us in the past, we would expect to be active with the buyback. And so last year, the ratio was strong. We bought back 10 million shares. And so as the ratio moved up towards 11.5% range, we would expect to be active there.

[Operator]

The next question is from Meny Grauman with Cormark Securities.

[Meny Grauman, MD & Head of Institutional Equity Research]

Question on the restructuring charge. Wondering why it wasn't an item of note or maybe to put it a different way, in the past, you've taken this restructuring charges and excluding -- excluded them from adjusted results. I'm wondering if there's a change in philosophy in the way you view the treatment of restructuring costs. Or is there something unique in this particular charge?

[Thomas E. Flynn, Chief Financial Officer]

Yes. It's Tom, Meny. Thanks for the question. I would say, to use your words, there is something different or unique in this charge. And the severance expense this quarter was in Capital Markets that reflected an adjustment made by the management of that business. And so we booked the expense in Capital Markets and didn't adjust for it because it was more normal course. And in contrast, we have, from time to time, booked enterprise-wide restructuring-related charges in our corporate segment, and we've adjusted. And that would continue to be our practice going forward if we had a charge like that. And the distinction really is between something that's closer to ordinary business versus a bank-wide initiative, which will result in us taking the charge in the corporate segment.

[Meny Grauman, MD & Head of Institutional Equity Research]

And just as a follow-up. In terms of the details of that charge, what specifically about the timing or the nature of the charge drove the charge? Was this related to some sort of specific issue that you see in Capital Markets?

[Daniel Barclay, CEO & Group Head]

It's Dan here. No specific issue, and I'd emphasize no change in strategy and through the process did not close any particular businesses. We generally like where we are and believe we're well positioned in where we want to go. The primary rationale was that we wanted to align our resources with the current market environment. As you know, we've made a strong commitment to deliver on the operating leverage. And this is part of that program for us to deliver on that. I think you'll note and you've heard it from Tom's comments earlier, we expect us to contribute to the bottom line immediately with an expectation of $40 million in savings this year and a run rate of $80 million next year. And so that was the piece behind it.

[Operator]

The next question is from Steve Theriault with Eight Capital.

[Stephen Gordon Theriault, Principal & Co]

A couple of things for me. If I could just start with the follow-up though. Tom, the direct from higher source currency RWA, can you talk through it a bit there? It was quite high. I'm struggling a bit, like loan growth in Q2 didn't look much different than loan growth in Q1. In commercial, loan growth was maybe a little bit stronger in Q2. But why such a much larger drag? Is it mix in terms of the CET1 drag this quarter?

[Thomas E. Flynn, Chief Financial Officer]

Yes. So a couple of things. Firstly, loan growth was a little bit stronger, but it was strong as well as Q1 -- it was strong as well in Q1. I think the biggest difference is that in Q1, we had the benefit of some offsets in a combination of methodology and quality. And so those changes helped mute the total RWA increase. And this quarter on the risk-weighted assets, it's actually a pretty clean quarter. The growth that you are seeing reflects the underlying growth in the portfolio. There's some FX, but that doesn't impact the ratio because we hedge that. So the big difference is, last quarter, we had a couple of things that helped us and the growth is higher.

[Stephen Gordon Theriault, Principal & Co]

Okay. That makes sense. And then on expenses, if we exclude the severance charge for this quarter, it's still below 2% operating leverage and you're below for the full year. So a couple of things, I guess. Is 2% still a reasonable bogey for 2019? And does the -- lower than 2% run rate, have you given any more consideration to a larger broad restructuring charge like we've seen in the past at more of an enterprise level?

[Thomas E. Flynn, Chief Financial Officer]

Okay. Thanks for the questions. So if you exclude the severance in the quarter, the operating leverage was about 1.2%. For the first half, it would be about 1.3%. And I'll just make a couple of comments about the expense growth itself. So over the first quarter, the expense growth or sorry, the first half, the expense growth has been a little above 7%. That includes about 1.2% to 1.3% of growth coming from each of FX and KGS and the severance expense added to the growth. And so adjusting for those things, the growth is lower, and we expect growth in the second half to be about half of the first half growth, which was 7.3% all in. And then if you look at our underlying growth in the business, it's actually quite low. So in the numbers, we've got the currency, the acquisition and the severance. If you take those out first half, expense growth is 2.6%. And we expect to be below 2% in the second half. So we are focused on containing expense growth and that will help with positive operating leverage. For the year, on an adjusted basis, including the impact of the severance, the 2% will be tougher to hit. We're expecting to be above 1%. And we do think the economics of the Capital Markets severance expense are attractive. And so in our decision-making, we pursue economics over headline numbers. And so the number for the year will be lower than 2% likely, but the economics are good. And if you were to adjust for the severance, we're very much focused on being above 2%. And so we're so focused on that and that's the expectation. And looking forward, the number we're focused on more than any other is the efficiency ratio of 58% in 2021. That basically assumes that we're hitting 2% leverage over the next 3 years. The severance expense won't recur, so it doesn't impact the efficiency ratio number looking forward. And I'd say we think we're on track for that.

[Operator]

The next question is from Gabriel Dechaine with National Bank Financial.

[Gabriel Dechaine, Analyst]

Yes. First question is on credit. And at first glance, it looks like the provision number in the U.S. particularly is too low relative to the level of formations you had this quarter. But if I peel it back a bit, I reverse that credit recovery and I don't look at the -- and I exclude the oil and gas formations where you say you're not going to give a loss out, I guess to about a 30%, I guess loss rate on the remaining loan. Does that kind of how you look at it possibly? And underlying that question as well given that formations were still high in the U.S., are you seeing any fallout from trade issues in the U.S. trade wars because you did see some ag and wholesale trade formations?

[Thomas E. Flynn, Chief Financial Officer]

Yes. Well, I'll talk specifically to formations. They -- we -- they're definitely up quarter-over-quarter. And as you can imagine, formations will vary a fair bit quarter-over-quarter, especially in wholesale where you have some lumpy things that come in and out. I think you need to look primarily at the formation rate particularly as the overall wholesale portfolio is growing. You're going to see the formation numbers start to drift higher just in an absolute sense, but the rate is really what's the most important thing. We see that formation rate being about 18 basis points this quarter. Compare that to Q2 of last year, it was roughly around 16, the 4-year average just around 15, the range is kind of 11 to 22. So the formation rate this quarter is pretty much consistent with that historical range. And if I dig underneath it looking for sectoral trends, there is a little bit of ag in there, you're right, particularly in the U.S. As you know, we're a dairy lender in Wisconsin and that segment is a bit -- is troubled. There's a little bit of an oil and gas theme in there. But nothing that I would point to as anything that would cause us to expect higher levels of PCL going forward.

[Gabriel Dechaine, Analyst]

Okay. That's a very thorough response. Then my next question is on trading. It seems like over the past few quarters, something magical happens at quarter end and you have a big spike in trading revenues, and this quarter was particularly strong. Can you help me understand the influence of how U.S. trading book is structured and maybe some of those fair-value adjustments that take place?

[Daniel Barclay, CEO & Group Head]

Sure, it's Dan here. So the revenues this quarter were impacted by the change in the funding rates that affected our structured notes program, which resulted in a gain. That was offset by some valuation adjustments for certain client trades that we had. As we think about those valuation adjustments, it's kind of normal course. Looking at that last trading day of the quarter, it was a very strong trading day to begin with. And so the 2 measures that I just talked about, the gain and the offset, really are about 75% of that's -- that bar that you see.

[Gabriel Dechaine, Analyst]

Okay. And just the last to sneak it in. Do you have any -- and Tom, perhaps you can answer it. The flat yield curve, is that creating any headwinds in your corporate segment in the liquidity portfolio?

[Thomas E. Flynn, Chief Financial Officer]

Yes. It's really not. Most of the liquidity portfolio we swap back, and so the flattening of the yield curve hasn't had much of an impact to our book given how we manage it.

[Operator]

The next question is from Scott Chan with Canaccord Genuity.

[Scott Chan]

Just on the U.S. side, what is your outlook on third-party originations? And I only ask that because GreenSky has been pretty topical lately with regional financials -- region financials kind of backing out with other commitment because of lower risk-adjusted returns. I was just wondering, how do you see that channel going forward?

[David Robert Casper, Chairman & CEO]

So that's not a -- this is Dave. That's not a huge channel for us, and the GreenSky specifically is a relatively new partner for us. We're not impacted at all by what you've discussed, it's still small. It's -- and we expect it to grow, but not -- it's not going to be a significant part of our business.

[Scott Chan]

Okay. And just on Capital Markets. With all the restructurings, going forward, do you intend to kind of add to any capabilities in Canada or the U.S. over the next year or so?

[David Robert Casper, Chairman & CEO]

We are always looking at our business overall in terms of how we like it. As I said earlier, we're feeling very comfortable where positioned and don't anticipate anything material. But always as market conditions evolve, we will add and subtract the necessary investments to look after those market opportunities.

[Operator]

The next question is from Sumit Malhotra with Scotia Capital.

[Sumit Malhotra, Managing Director of Canadian Financial Services]

First, for Dave, on net interest margin and yield outlook in your business. You had suggested that the NIM would step back from Q1, and we saw that maybe a bit larger than I was thinking. Just kind of put this in context and not necessarily thinking about next quarter, but with fed rate hikes seemingly off the table and at least some conversation about cuts, just kind of curious as to whether continued compression should now be the outlook for this business going forward. Or is the offset coming in pricing on the commercial side? Are you seeing any stabilization in loan pricing in the market as a result of maybe making in some credit risk protection? Or is compression as a result of competition also a factor we need to bake in here?

[David Robert Casper, Chairman & CEO]

So there's a couple of questions in there, but I think it was mostly around what you should expect going forward. And I'd say and I won't -- I'll be happy to unpack what happened in the past if you want. But going forward, I would expect much more stabilization. We -- and quarter-to-quarter, as you pointed out, there's a lot of things that can happen that move it around. But longer term, I would expect it to be more stable. There could be some drifting downward, more really tied to some pressure on deposits as we continue to grow our loan book. But long term, more stable, maybe a little bit down on the deposit side. Does that help?

[Sumit Malhotra, Managing Director of Canadian Financial Services]

What about loan pricing specifically? Is that where you're seeing stabilization? Or is the competition for loan growth still putting double pressure on spreads?

[David Robert Casper, Chairman & CEO]

So I think it's -- it'll always be a factor. Pricing will always be a factor, and we compete on everything. But we don't very often win on price. So I don't expect that to be a big factor for us. To the extent that, over time, we actually have -- we're booking higher credit quality, there just a natural compression in spreads there with higher credit quality. But overall, I don't see that competition being very significant for us and it's, it's a factor. But as I say, we rarely win on price. We compete on everything, but we rarely win on price.

[Sumit Malhotra, Managing Director of Canadian Financial Services]

And then I'm going to wrap up with Pat. I think there's been some questions, Pat, on kind of the interplay, if you will, between the very large corporate and commercial loan growth that the bank is generating and provision rates or charge-off rates that are at the low end of the sector. And looking at some of your slides over time, I -- the credit performance of BMO has consistently been at the low end of the group, and I think your business mix has spoken to that. Is there anything from an early warning indication, I mean the market seems to be quite concerned about late cycle. I'm not really hearing that tone from the bank. What are the factors that have given you confidence? Is it relatively new in your role that commercial loan growth of 15%, corporate loan growth almost double that, is still a appropriate risk management approach for BMO at what seems to be a later stage for the cycle?

[Patrick Cronin, Chief Risk Officer]

Yes. Thanks for the question. And obviously, we read the same things that you do about late cycle. I can put it into really a couple of categories. First, when we look at the current portfolio, notwithstanding the growth, I'll go back to my earlier comments. We see a very consistent to actually improving credit quality, both in the overall book and with respect to new additions. We see very good diversification and very strong lending practices. And when I look through formations in GIL and even watch list, we're just frankly not seeing signs of stress other than small minor pockets and sectors. So that's the first comment I'll make. As we look forward, though, first, I look at in the views of our own economics group. And as we look out through F '19 and F '20, we see a pretty stable environment, frankly. We see while some moderation in GDP growth but at still relatively stable levels. We see strong unemployment levels, housing prices fairly stable. And for -- and most importantly, fairly stable interest rates. And so I wouldn't call that a super strong economy, like maybe we saw in 2018, but certainly an economy that, in our view, from a risk perspective can sustain continued growth. And then lastly, I know I don't frankly think about a target growth rate. As I said earlier, that growth rate is really going to ebb and flow based on the supply of attractive opportunities. And we went through a period of growth through 2014 and '17 that was pretty much the same as what you would have seen this year. But in between there, we would've seen very low growth rates. And so we're not targeting a specific growth rate, we're targeting attractive opportunities from a credit perspective. And from our risk view, what we've seen so far is very consistent with the credit quality that we want. We'll obviously monitor things very closely. And we do a lot of things with respect to stress testing for recessions. And so as we look at what the magnitude of those losses can be, both in severe or even very severe scenarios, we don't see an outcome even with a larger wholesale book that would cause us concern relative to the earnings power of the bank.

[Operator]

The next question is from Mario Mendonca with TD Securities.

[Mario Mendonca, MD & Research Analyst]

Could we just go to the recoveries we've seen over the last few quarters? Recoveries are certainly not unique to BMO. We've seen them across the industry, but they've been especially relevant to BMO. What would you say about those 2 recoveries, the one last quarter and this quarter? They clearly are not related to the same company or industry. But when you look at these sorts of recoveries, and again, not unique to BMO, what is driving this? Is there anything macro that might be driving this? Or are these idiosyncratic in some respect?

[Patrick Cronin, Chief Risk Officer]

Yes. Thanks for the question, it's Pat. I would say it's not macro. I would say it's really more a function of the fact that we're really tenacious about chasing recoveries. The last couple of quarters, these ones would have been ones from years ago that we just simply don't give up on. On top of that, I would say we have a really strong workout team. And so for us, that provision is just the beginning of the story. The workout team spend years going through these files, mostly focused on getting those clients back into performing status and back into the businesses. But in situations where we go through a workout, I just think we're really good at recoveries. This one, in particular, relates to a legacy M&I position and a fairly complicated bankruptcy and resolution process that we worked our way through for many years, and we ultimately got paid out. And so I don't think of recoveries as uncommon. I don't think of them as idiosyncratic. I think of them as a normal part of taking PCLs off and you get recoveries. And if you're good at working through the PCL process, you're more likely than not to get them.

[Mario Mendonca, MD & Research Analyst]

And this isn't financial, that's a broad category. Can you offer anything else on that? The recovery that is.

[Patrick Cronin, Chief Risk Officer]

The specific one?

[Mario Mendonca, MD & Research Analyst]

Yes. You said it was financial, $40 million in recoveries.

[Patrick Cronin, Chief Risk Officer]

Yes, sure. This relates to, as I said, a legacy M&I account that was fully written off when we had purchased M&I. But like I said, even though it was written off, we still worked through a recovery process. It was a financial institution. And so an FDIC resolution process takes a lot longer than others, but we worked our way through it. We did get paid out this quarter. And we booked that this quarter against PCLs in accordance with our policy.

[Mario Mendonca, MD & Research Analyst]

Okay. And then on the oil and gas, $126 million impairment this quarter, but you don't expect any PCLs. What specifically about this exposure leads you to believe there wouldn't be no PCLs?

[Patrick Cronin, Chief Risk Officer]

Well, there's a bunch of things that can potentially be at work there, but not the least of which would be asset coverage. And so as you know, a lot of the exposure in that sector would be reserve-based lending. And so while they may go impaired, that then triggers a process of either asset sales or a workout. And so when we look at our -- the asset coverage relative to our loan, we feel comfortable. Obviously, that may change as we go along. But at this stage, when we look at what's in that impaired portfolio, we feel relatively comfortable that the PCL experience will be moderate.

[Operator]

The next question is from Darko Mihelic with RBC Capital Markets.

[Darko Mihelic, Financials Analyst]

I hope you'll indulge me with a couple of questions here. The first one -- just going back to Pat. Can you just provide a little bit of color, you mentioned in your remarks that you implemented a new collection system. And I was just curious why now? Was there something changed? And does this collection system only handle mortgages? Or does it go across other consumer portfolios?

[Patrick Cronin, Chief Risk Officer]

Yes. Thank you for the question. There's nothing particularly magical about the timing. We look to improve our systems all the time. This was a legacy system that was just due for an upgrade. It Included some significantly improved functionality that we think would be really beneficial to the collections process going forward. As often can happen with implementations of that size, there were a couple of hiccups that caused us to fall behind on collections. And -- but those have been now corrected at a result in some temporary increases to delinquencies through the delinquency spectrum and also maybe a little bit of higher loss rates. We've applied a lot of additional resources to chase after those delinquencies. But ultimately, we think it'll be beneficial, it's just caused a little bit of short-term increase in the delinquency numbers.

[Darko Mihelic, Financials Analyst]

And it's just mortgage-specific? Or is it...

[Patrick Cronin, Chief Risk Officer]

I'm sorry, no, it covers cards and mortgages and personal loans.

[Darko Mihelic, Financials Analyst]

Okay. And a second question. Darryl, in your opening remarks, you touched upon your Investor Day, and -- but we don't really have much. I mean, it hasn't been that long, but I'd be very curious to understand where you are with respect to your target of $1 billion in savings by 2021. And if we think about the expense issue, you sort of offered up at one point during your Investor Day, how much it takes to run the bank and how much we're investing in technology. Has that changed significantly since the Investor Day at all?

[William Darryl White, CEO & Director]

Yes. Darko, thanks for the question. It hasn't changed significantly. In fact, I would say it hasn't changed at all. So when I look at where we are on our targets that we laid out for you then, as I tried to explain in the opening remarks, we feel like we're very much on target. We're delivering on those savings as we go through. We, in fact, think we'll bring in more savings than we thought at the time, and some categories were ahead of our targets. The severance cost that you saw on the Capital Markets pillar, this particular quarter wasn't on the table when we made that commitment. So that would be net new in terms of those -- the savings that Dan outlined. There's another $40 million in here and another $80 million thereafter that we could add to the tally. And on the theme of investing in the businesses at the same time, there is also no change there. Darko, we've said a few times that as we continue to target 2% operating leverage, and you heard Tom express his confidence on that in the question earlier in the call, we continued to invest in technology. We've, over the last couple of years, had a increase in our technology spend by over 10%. And this year that continues. And despite that, our net cost increases, Tom summarized them for you earlier, once you back out severance in currency and acquisition, are in the mid-2s and going down in the second half of the year. So we feel good, net-net, feel really good about the mix in terms of what we're delivering on operating leverage and what we're delivering on investment and no change relative to what we said back in the fall.

[Darko Mihelic, Financials Analyst]

Okay. And forgive me for the next -- for sneaking in one more question, and it's going to be very frank. The discussions I've had with a lot of investors since your last quarterly update, the number one concern that I've been getting with your company is that there is a concern out there that perhaps you would be willing to make a large acquisition in the U.S. and significantly dilute down shareholders. So the question isn't really the usual capital deployment question, I'm not really interested in that. What I'm interested in this, is there anything that's changed in what you look for with respect to an acquisition? Has there been anything that's changed in the landscape in the U.S. that might heighten your appetite for it? And yes, I'm just curious as to why that comes as a large pushback on your stock in the last quarter? And perhaps, it's just related to your relative valuation, perhaps that's just it, but I'm just wondering if there's anything there, Darryl, that you can talk to. And again, I'm not interested so much in your capital deployment preference and so on. I'm really just specifically interested in your view on acquisitions and whether or not the appetite's really significantly changed?

[William Darryl White, CEO & Director]

Yes. I know I -- thanks for the question, Darko. And I think you phrased the question well, has anything changed? The answer to that is flatly no. We've always considered acquisitions. We've taken you through our criteria before. We're disciplined about how we think about it. And at the same time, I don't know how much more deliberate we can be in saying organic growth comes first. And we've said it time and time again, and it's -- I think when we look back, we're proving it. When I think about the place people usually go with us is questioning us on appetite for U.S. acquisitions, as you just did. Then you look at the fact that we're run rating over $2 billion of annual earnings from our U.S. operations today. We do not have a scale problem in the United States, and we are able to invest with the benefit of the balance sheet that has over $800 billion of assets globally. Our growth rate in our U.S. businesses year-to-date, net income is 29%, almost entirely organic. So when I've said time and time again to this question in investor meetings and with you guys on the call that we don't feel any compulsion, it's because what we're doing is working. And so I don't know what else to tell you other than, yes, we always look. Yes, we're disciplined. No, nothing has changed. And organic first, and our strategy is working.

[Operator]

The next question is from Nigel D'Souza with Veritas Investment Research.

[Nigel R. D'Souza, Investment Analyst]

I know you've spoken to this at a high level for your commercial book as a whole, but I wanted to drill down a bit more and touch oil and gas again. And I bring this up only because the formation that you're seeing in U.S. oil and gas commercial loans isn't unique to BMO. So I'm wondering if you could provide -- well, the first part is I'm wondering if you could provide more color on what's driving that, given the fairly robust rally commodity price in WTI was near $70 at the end of April. And the second part of the question has more to do with the Canadian side. There's some discussion now that the spread between WCS and WTI pricing could widen if Alberta relaxes production curtailments. So can you just provide an outlook or a sense of the domestic oil and gas exposure that you have in Canada? And what your outlook is for that book?

[Patrick Cronin, Chief Risk Officer]

Sure, it's Pat. So thanks for the question. First, let's put it in context. There are oil and gas portfolio, in its entirety is 5% of wholesale loan. So it's a relatively modest. And included in there would be about 51% of that exposure would now sit in the U.S. So relevant to your WCS versus WTI question, the exposure is relatively modest. In there, it also includes about 40% of the oil and gas portfolio that's in pipelines and manufacturers and refiners that aren't exposed to some of those same things that you referred to. Now with that said, obviously, we're seeing the same things, formations and GIL are up slightly quarter-over-quarter in the oil and gas sector. As I said earlier, there are some lumpy things that come in there from time to time. I would say there's probably 2 or 3 accounts in there that are driving the majority of what you're seeing quarter-over-quarter. I, at the moment, we don't see anything thematic in there. Those things come in from time to time. As I said before, we'll work through those and based on asset coverage and our view of a sale process, we think we actually will experience, what I would call, moderate PCLs. I'm not going to say none, but nothing that I would say would be a cause for concern for us. And with that said, we're obviously going to watch it really closely. We pay a lot of attention to this sector. We're really good at it. We've got years and years of experience in the oil and gas sector, including through some really tough times. And so if we do see a trend of weakness in this sector, we think we're well positioned both from a size perspective, a diversification perspective and an expertise perspective to manage through it.

[Nigel R. D'Souza, Investment Analyst]

Got it. So I just wanted to quickly just summarize more idiosyncratic right now and not sectoral. And I'm reading that your expectation is stability in commodity pricing. Is that fair in terms of your outlook in the call that you've given?

[Patrick Cronin, Chief Risk Officer]

Yes. I'll give you just simply our economics outlook, which is that for stable oil and gas prices. If you look at the U.S. Energy Information Association (sic) [ U.S. Energy Information Administration ], they would have the same kind of an outlook for stable prices. So that is relatively speaking our view. And I would agree with your comment that at this point, it seems more idiosyncratic to us but like I said, we'll watch it carefully, and if it turns out to be something more than idiosyncratic, we think we're well positioned to weather it and manage it.

[Operator]

This concludes the question-and-answer session. I would now like to turn the meeting over to Darryl White.

[William Darryl White, CEO & Director]

All right. Thank you, operator. As I summarized earlier, we feel good about our performance in Q1 having earned through a severance cost with strong operating performance across our businesses. In fact, our performance for the first full half of the year was strong, and we're confident in the opportunities to continue delivering good results for the second half, which we expect to be similar to the first. That confidence reflects the progress we're making in executing our strategies, investing in the target areas of strength for sustainable growth and the benefits of our highly diversified but tightly linked mix. In all of our businesses, we're adding customers. We're expanding relationships. We're deepening loyalty, which we see in improving Net Promoter Scores.We're continuously enhancing our technology and digital capabilities. We're collaborating to deliver the best of BMO to our customers holistically and seamlessly. Canadian banking, which we didn't talk about a lot on the call, is delivering stable earnings growth, strong loan growth and deposit growth and strong returns in here. We see widening operating leverage in the back half of the year. The same is true for U.S. P&C, where consistently strong commercial performance is complemented by real momentum in retail and in deposit growth. And we are expecting improving earnings in Wealth and Capital Markets through the end of the year.And before closing, I'd like to express my deep concern for our customers and employees and communities affected by severe spring flooding in many of our markets in Canada and the United States and threatened by wildfires in northern Alberta. Supporting our customers through these extremely difficult times is a priority, and we've provided support indirectly through the Red Cross and are offering financial relief programs directly for our impacted customers.So thank you all for joining us on the call today, and we look forward to speaking you -- with you again in August.

[Operator]

Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you all for your participation.