Laurentian Bank of Canada

TSX:LB

Earnings Call Transcript 2020-Q2

[Operator]

Good day, Bonjour. And welcome to the Laurentian Bank Financial Group's Q2 2020 Financial Results Conference Call. Today's conference is being recorded.And at this time, I would like to turn the conference over to Ms. Susan Cohen, Director, Investor Relations. Please go ahead, ma'am.

[Susan Cohen, Director of Investor Relations]

Good morning. And thank you for joining us on our earnings call where we are all calling in from different remote locations. Today's review of the second quarter of 2020 results will be presented by François Desjardins, President and CEO; and François Laurin, Executive Vice President and CFO. All documents pertaining to the quarter, including Laurentian Bank Financial Group's report to shareholders, investor presentation and financial supplements can be found on our website in the investor center.Following our formal comments, the senior management team will be available to answer questions, and then François Desjardins will offer some closing remarks. Before we begin, let me remind you that during this conference call, forward-looking statements may be made, and it's possible that actual results may differ materially from those projected in such statements. For the complete cautionary note regarding forward-looking statements, please refer to our press release or to Slide 2 of the presentation. It is now my pleasure to turn the call over to François Desjardins.

[François Desjardins;President and CEO]

Thank you, Susan, and good morning, everyone. These are challenging times, and COVID-19 has had a profound impact on our economy, customers and communities. Despite the many hardships that have resulted from this crisis, it has also demonstrated our ability to proactively manage through and adapt to the situation in order to provide service to our customers. I'm particularly proud of the team members who are able to quickly take charge of the work required to ensure that our customers receive the support and advice they need, now more than ever.For as far as this environment persists, our actions will be aligned with the following priorities: to keep our team members and customers safe, to provide the financial help and support our customers need, to position ourselves to withstand any uncertainties still yet to come, to take advantage of growth opportunities and last but not least, complete our strategic plan. With approximately 80% of our team members working from home and most of our financial clinics, business centers, operations and call centers fully operational, day-to-day banking continues to be accessible. Team members have been able to help customers over the internet, phone and in person. Our CET1 ratio stands at 8.8%, well in excess of the minimum regulatory requirement and our revised operating level that now stands at 8.1% to 8.5%. We have a high level of liquidity and the provision for credit loss ratio continues to be lower than the banking industry. We have strong capital and liquidity position and disciplined risk management but this is a time for prudence. Although we still believe that current earnings are not reflective of future earnings power of the organization, we have reduced the quarterly dividend to $0.40 per share, which improves operational flexibility until we reap the anticipated benefits of our strategic plan.In terms of financial performance, for the second quarter, Laurentian Bank Financial Group reported adjusted net earnings of $11.9 million, diluted earnings per share of $0.20 and an adjusted return on equity of 1.5%. COVID-19 has had a negative impact on operating income in the second quarter and the underlying improvements in the quarter were overshadowed by the increase in provision for credit losses.In the second quarter, loans to business customers grew by 3% or 11% on an annualized basis, in line with our guidance for double-digit growth. And net interest income was 4% higher than a year ago, mainly due to a greater proportion of higher-yielding loans to business customers. This is demonstrating that our plan to improve the business mix is working. I'm encouraged by the business development results with respect to the mortgage and personal loan portfolios, where we have seen increased demand over the last few months and early signs of stabilization. Capital markets has had very strong results, generating good growth in revenues, largely from its fixed income business. On the expense side, we reduced our workforce by about 200 people, of which about half was in early May. In the second quarter, we reviewed our expenses, and we'll continue to do so going forward as we work towards improving efficiency. Now on to strategic initiatives. In the current environment, we are reviewing the timetable of our investments with an end goal that remains the same. We will complete what we started, setting a strong foundation, work on a profitable growth and enhancing performance. More than ever, digital technology is part of our data-led life. Advancing technologies and eliminating all nonessential paper-based transactions are required in a modern financial institution. Phase 2 of the core banking system replacement has already begun. This final phase includes the migration of all remaining products offered in the financial clinics and business services. By mid '21, all new personal customers will be onboarded digitally on the new core banking platform, and we will begin the migration of existing personal banking customers, which is targeted to be completed by the end of calendar 2021. This will enable all of our customers to enjoy a much-improved experience in managing their accounts and day-to-day transactions. The migration of remaining business customers is now scheduled to start in November 2021, a 6-month delay from what was previously announced. Phase 2 should, therefore, be completed by early '22, after which we will be able to progressively decommission our legacy systems and gradually eliminate the associated operating costs.For financial clinics, the 100% advice model is gaining momentum. We are expanding the adviser team, which now stands at 400, having onboarded about 25 new advisers since the beginning of the year. As customer behaviors continue to shift from in-person visits to virtual, we are further optimizing our footprint and expect to have 63 locations by year-end, down from 83. Following the launch of LBC Digital, our coast-to-coast direct-to-customer channel, we are broadening and deepening our relationship with these customers and developing a complete high-value product suite.At the end of the quarter, deposits from this channel stood slightly above $700 million, in line with our expectations. With this digital offering, we are well positioned to take advantage of the expected acceleration in consumer adoption of digital banking. Although we firmly believe in the benefit of moving to the AIRB approach, in the current context and given what we are -- that we are prioritizing growth and efficiency initiatives, we are reviewing the timetable for AIRB that was due to be completed by the end of '22. For now, we expect a delay of at least a year. When we started the year, I had high degree of confidence that 2020 would be a year in which we would return to growth and that the heavy lifting would come to an end. Recent events have certainly changed the timetable, but not our resolve. While these times are challenging, they have also brought out the best in us. It is in these times that you define what your organization stand for. How we treat our customers today will be remembered for years to come.I would like to thank our customers for their business, our team members for their dedication and our investors for their continued support. We are building a better and different financial institution and our commitment to helping customers improve their financial health will not waver in good times and bad.I'll now turn the call over to François Laurin to provide a more detailed review of our second quarter results. François?

[François Laurin, Executive VP of Finance, Treasury & CFO]

Thank you, François. Good morning, everyone. I would like to begin by turning to Slide 10. As François just mentioned, the financial impact of COVID-19 in the second quarter of 2020 reduced profitability compared to last year and last quarter, essentially as a result of higher provision for credit losses.As outlined on Slide 11, adjusting items for the second quarter totaled $0.07 per share. Slide 12 highlights total revenue for the second quarter of 2020 of $240.1 million, which was relatively unchanged from last quarter and last year. Net interest income increased by $6.2 million compared to last year and by $2 million compared to last quarter. These increases were mainly due to an improvement in business mix with their proportion of a higher-yielding loans to business customers as well as an improvement in funding costs through the greater use of secured funding. This was partially offset by a decrease in loan volumes to personal customers and the unfavorable impact of the decrease in the Prime/BA spread.As shown on Slide 13, NIM in the second quarter of 2020 was 1.88%, up 11 basis points compared to a year earlier and up 7 basis points sequentially, mainly due to the change in the loan portfolio mix and the improvement in funding costs and was partly offset by the decrease in Prime/BA spread. The proportion of commercial loans in the portfolio stood at 40% versus 37% a year ago as we are successfully executing our strategic plan to evolve the bank mix towards higher-margin commercial loans.Other income, as presented on Slide 14, totaled $69.4 million. The $5.9 million decline from last year was largely explained by a $1.9 million decrease in service charges as the retail banking environment and related customer behaviors evolve. A $1.7 million decrease in card service revenues as transaction volumes declined driven by a reduction in consumer spending since the beginning of the pandemic and a $1.6 million decline in insurance income as customer claims increased. Sequentially, other income slightly declined as the same factors were partially offset by a $1.6 million increase in fees and securities brokerage commissions, mainly due to strong results on fixed income operations.Slide 15 highlights adjusted noninterest expense of $179.6 million, which rose by $3.4 million year-over-year. Salaries and employee benefits increased by $3.5 million, mainly due to higher wages and special compensation paid to team members who were required to work in financial clinics or in our corporate offices during the pandemic of about $0.5 million as well performance-based compensation increased mainly due to brokerage operations and other sales-driven compensation and business services.Premises and technology costs were relatively unchanged year-over-year and included cost of $0.5 million associated with precautionary measures, such as increased cleaning and reinforced security to enable 80% of our team members to work remotely. Adjusted noninterest expenses improved by $3.1 million sequentially, mainly due to lower share-based compensation and overall expense control despite the COVID-19-related costs just mentioned of about $1 million. The adjusted efficiency ratio of 74.8% in the second quarter of 2020 remains high. We're maintaining our focus on improving efficiency. As François mentioned, continuing to optimize the network of financial clinics and reducing our workforce to better align with our operational needs are expected to contribute to this objective. These measures will generate an impairment charge related to lease contracts and severance costs of approximately $6 million in the third quarter of 2020.Slide 16 highlights our well-diversified sources of funds. In the second quarter of 2020, deposits stood at $25.3 billion, essentially unchanged from the prior period. Core direct personnel deposits sourced through financial clinics increased for the second consecutive quarter and demand deposits through intermediaries also increased while term deposits sourced through advisers and brokers declined. The digital direct-to-customer deposits reduced in line with expectation. Securitization activities increased by $400 million during the quarter as we continue to optimize our sources of funding.In the context of evolving global pandemic, we continue to prudently manage our level of liquid assets. In March, financial markets became extremely volatile causing severe disruption to business and economic activity. To support our customers and provide the bank with necessary buffers, we increased our liquidity level. Like all banks, we participated in various Bank of Canada programs to further diversify our funding sources at a lower cost and maintain higher liquid assets.Slide 17 presents the CET1 ratio under the standardized approach of 8.8% at April 30, 2020, and highlights our healthy capital position. The impact of the OSFI transitional arrangements for provision for credit losses represents a positive adjustment to the CET1 ratio of about 10 basis points at the same day.Our diversified loan portfolio is shown on Slide 19 and stands at $33.7 billion or 1% higher than at the end of the first quarter. Launched the business customers continue to be our growth engine and increased by 3% sequentially, fueled by inventory and equipment financing activities.Slide 20 highlights our residential mortgage portfolio. At April 30, 2020, 50% of our mortgages were insured. Our Alt-A portfolio totaled $1.1 billion and represented 7% of our total mortgage book and 3% of the total loan portfolio.Slide 21 highlights our well-diversified commercial loan portfolio, which is Pan-Canadian with a U.S. presence. At $13.5 billion at the end of April, this portfolio grew 3% sequentially, mainly due to growth in inventory and equipment financing. In response to COVID-19, we continue to work with our customers. We may need flexibility in managing their loan and are offering up to 6 months of payment deferral for residential mortgages and some personal loans. For commercial loans, customer requests and deferral programs are reviewed and approved on a case-by-case basis. These payment relief options allow customers to temporarily stop making their regular payments while interest continues to accrue on the outstanding balance.As shown on Slide 22, at the end of the second quarter, we had authorized deferred payments of 19% of our mortgage portfolio for up to 3 months. Insured, conventional and all day mortgages account for relatively similar proportion. The value of deferred payments for mortgages was $50 million for the deferral period. With respect to personal loans, at the end of the second quarter, we had authorized deferred payments of about 0.1% of that portfolio with a deferred payment value less than $1 million for the deferral period. As well, deferred payments were authorized for 11% of loans to business customers at the end of the second quarter and the value of deferred payments was $58 million for the period. Payment deferrals are not considered to automatically trigger a significant increase in credit risk. Our results in such loans being mostly stage 2 or 3 when calculating expected credit losses, or ECL. There hasn't been a material change in the level of authorized deferred payments during the month of May.I would now like to discuss our disciplined approach to modeling expected credit losses. As a result of the deterioration in economic conditions caused by the spread of the COVID-19 pandemic and the related increase in economic uncertainty, 3 forward-looking economic scenarios: base, upside and downside were updated and used for estimating in ECL at April 30, 2020.The key assumptions are highlighted on Slide 23. High weights were assigned to the base and downside scenarios and the small residual weight was assigned to the upside scenario. Our ECL models were adapted to consider the recently announced monetary and fiscal measures to promote liquidity in these financial stress on individuals and businesses. Judgment was also applied to account for this unprecedented situation.Turning to Slide 24. In the second quarter of 2020, the provision for credit losses was $54.9 million compared to $9.2 million a year ago and $14.9 million in the prior period. The increase was mainly a result of higher collective allowances. Specifically, credit losses and personal loans in the second quarter of 2020 were $17.4 million compared to $4 million in the previous period. The increase mainly related to stage 1 and 2 credit losses of $9.6 million compared to recoveries in the previous period and was essentially a result of the significant increase in credit risk due to COVID-19. Credit losses on residential mortgage loans remained relatively unchanged at $1.4 million in the second quarter compared to last quarter and reflects strong underwriting criteria.Credit losses on commercial loans totaled $36.1 million compared to $9.5 million in the previous quarter. Stage 1 and 2 provisions rose to $21 million from $927,000 last quarter as a result of the negative impact of COVID-19 on collective allowances and individual allowances on a limited number of loans. Stage 3 provisions were $15 million, up from $8.5 million last quarter, reflecting impairment charges for nonperforming loans.As shown on Slide 25, the provision for credit losses as a percentage of average loans was 57 basis points for the second quarter of 2020 compared to 18 basis points in the previous period. This ratio continues to favorably -- to compare favorably to the industry, reflecting our disciplined underwriting standards and the strength of the collateral. The magnitude of the COVID-19 impact on the Canadian and U.S. economies remains highly uncertain. Therefore, it is difficult to predict whether the increase in expected credit losses will materialize into a significant level of write-offs or reversals and if the bank will recognize additional increases in expected credit losses in subsequent periods.Impaired loans are shown on Slide 26. Gross impaired loan totaled $235.2 million, up $48.5 million sequentially, mainly due to an increase in the commercial loan portfolio. The allowances for loan losses against impaired loans increased by $13.8 million from the previous quarter, mainly driven by an adverse shift in forward-looking economic scenarios related to COVID-19. Short term, we, like most businesses, have little visibility on the course of the pandemic or the performance of the economy. But as the pandemic wanes and we gain greater clarity, we will update our midterm objective.To conclude, our response has been quick and our actions have been prudent. We are well positioned to navigate through these challenging times and we will be prepared for the future. In the interim, the operational flexibility that we're building along with the healthy capital and liquidity levels allows us to support our clients, improve our business mix and grow profitably.Thank you for your attention, and I will now turn the call back to Susan.

[Susan Cohen, Director of Investor Relations]

Thank you. At this point, I would like to turn the call over to the conference call operator for the question-and-answer session. Angel?

[Operator]

[Operator Instructions] And we will take our first question from Sumit Malhotra of Scotia Bank.

[Sumit Malhotra]

First question, just thinking about the trend line in capital. You mentioned that you have lowered your expected -- your target range for the CET1 ratio. And then frankly, I think that's understandable in this environment. With respect to the reduction in the dividend, do you expect that, that will keep you in this target range? I know you're above that right now. And maybe more to the point, what type of risk-weighted asset inflation are you expecting as we go through this cycle, obviously, your increase in RWA this quarter was pretty limited at 1%.

[François Desjardins;President and CEO]

Thank you, Sumit. We have strong capital and liquidity positions and disciplined risk management. But as you said, this is a time for prudence. Although we still believe that the current earnings are not reflective of the future earnings of the power of the organization, it is uncertain times with COVID-19 pandemic upon. And this decision improves operational flexibility, ensures that we can move forward confidently, aim for growth efficiencies, absorb credit losses should they arise and complete the long-awaited strategic objectives. We prefer to go forward with an abundance of caution, so a reduction in the quarterly dividend better aligned with our dividend policy in a pre-COVID world is best until we reap the anticipated benefits of the strategic work we're doing.We are keeping the payout ratio at between 40% and 50% going forward, target ratio.

[William Mason, Executive VP & Chief Risk Officer]

Sumit, it's Liam. Just in terms of RWA growth, it really -- as you noted, we had modest growth driven by the growth in business services. Really the growth depends on how the economy evolves. If we see things coming back, we will grow commensurate with the market. We have targeted plans as François laid to grow our business. But how the RWA evolve really depends on how the situation changes.

[Sumit Malhotra]

And sorry, Liam, to be clear, I get the business piece and how that affects RWA. My question is more, what is the bank assuming with respect to RWA inflation arising from credit migration as we go through the next several quarters and presumably the underlying credit quality metrics begin to deteriorate and then you move through your models? Is that something...

[William Mason, Executive VP & Chief Risk Officer]

I can give some general -- I mean I'm not expecting a lot driven by the mortgage portfolio, given the relatively low loan-to-value that we have. With the equities markets improving, some of the pressures that would have been on RWAs from our investment loans are coming off. But obviously, that's one area of pressure. And then with regard to migration, given the strength of our portfolios right now, I don't expect a lot of impact beyond that to our RWAs, but we'll see how things evolve.

[Sumit Malhotra]

And some of this is obviously the benefit you're still getting from being under the standardized approach. Is that fair to say?

[William Mason, Executive VP & Chief Risk Officer]

Some of the benefit is, yes. But I would remind you that from a -- in terms of our estimate, on an AIRB equivalent basis, we'd be approximately 200 basis points higher. So when François said, it's a target range of 8.1% to 8.5% on a standardized basis, that's an equivalent AIRB target range of 10.1% to 10.5% based on our view of AIRB.

[Operator]

And we will take our next question from Sohrab Movahedi of BMO Capital Markets.

[Sohrab Movahedi, Analyst]

I mean you've obviously talked to the economic uncertainty. It's a big degree of complexity on the strategic transformation program. I just -- I wonder if you could just talk us through how you decided on the order of magnitude reduction of the dividend. I mean I guess, just trying to understand how the thinking went through it. Why -- I mean this is by 40%, not 80% or 20%. I'm just -- is that something to talk to you a little bit?

[François Desjardins;President and CEO]

Absolutely. Obviously, when we went into the year after 1.5 years of labor lows, et cetera, I started the year by thinking that we would earn our way out of it. And that earnings would come back faster as we plan to -- I announced the year as being a year in which the heavy lifting would be coming to an end, and we would focus on growth. Obviously, COVID changes that slightly by introducing higher provisions for loan losses and delays just in terms of priority in terms of serving clients, which is the ultimate priority in these times. So we just made the prudent choice to say, well, what -- how do we have better aligned the dividend payout with the policy in a pre-COVID world. And instead of trying to earn our way out to -- like we plan to do, is make the cut right now, stay prudent. And as earnings go back to what they should be in a post strategic-planned world, then the dividend would grow along with it.

[Sohrab Movahedi, Analyst]

Just François, just I appreciate that. And I think it is prudent. I'm not questioning the prudence. I just want to know how you arrive at the order of magnitude of reduction or what gives you comfort that at this new level you will be able to operate within the target there?

[François Desjardins;President and CEO]

Thank you. Well, we took several factors into consideration. The first of which is the fact that in a pre-COVID environment, we were at 9% CET1. And we finished the quarter at 8.8%, and that our revised target for operating at CET1 level is a range of 8.1% to 8.5%. So we have quite a bit of capital room here to be able to withstand any future losses, continue our growth plans, et cetera. And we didn't feel that it was required to go any further than what we did. And from trying to set the level, discussions around where were we in the last few quarters of last year, we were at a payout ratio that was higher than our policy and trying to set expectations in terms of where should we be at this level was -- these are the factors that influenced our decision-making.But if your question is, what gives you comfort? I would think that the buffer that we have in terms of operations is a great comfort to me.

[Operator]

We'll now take our next question from Gabriel Dechaine of National Bank Financial.

[Gabriel Dechaine, Analyst]

The dividend cut is one strategy to preserve capital. I'm wondering if you're evaluating others. You've done the DRIP discount. Are you looking at any portfolio sales potentially to reduce the RWAs if not in the past, but maybe the harder look at that strategy today?

[François Desjardins;President and CEO]

Thank you for the question, Gabriel. No, we are not looking at portfolio sales at all. We are looking at growth in our portfolios. And no large-scale acquisitions, like we've said in the past, but small portfolios, we'd be open to looking at that. We want to put more assets on the balance sheet. And we've said so for the last year or so, and we've been working very hard and successfully on the business customer side. As we've said in our remarks, this has continued to be a growth engine for us. And turning around the personal customer side has been our focus. I'm encouraged by the organic business development activities that we've been seeing. We've been slowly coming up the ranks in terms of market share on the mortgage broker business. And we've seen recently, our efforts start to pay off on personal loan side as well. So we're seeing some signs of stabilization. So really, as we're going through this crisis. Now that everybody's home or 80% of our team members are home, we're open for business and we're looking for growth. From a DRIP perspective, obviously, we discussed that every quarter, and we'll discuss that again next quarter. But for the time being, given that these are unprecedented times, we just left the DRIP as is for now, and we'll see what we do with that at the next quarter. For the moment, it gives us extra flexibility on capital. And of course, more capital means more growth.

[Gabriel Dechaine, Analyst]

The comment about your economic scenarios and putting a heavier skew on the base case and the pessimistic case, that's what you use to determine your performing provision this quarter if I understand it correctly. The base case is, if I got it, it's pretty much of E-shaped recovery. So like by Q4 -- sorry, early 2021. We are back to pre-COVID GVA growth levels? Is that how I should look at it?

[François Desjardins;President and CEO]

Liam, you want to answer that?

[William Mason, Executive VP & Chief Risk Officer]

Yes. Thank you, Gabriel, for the question. We calibrated our scenarios based on -- I'm sure you saw the ranges of scenarios that the Bank of Canada put out and all of the DSIBs put out and provided economic scenarios. And our calibration in terms of our base case, the favorable case and the pessimistic case, we're based and aligned with what we saw in the industry and the Bank of Canada provide.

[Gabriel Dechaine, Analyst]

Right. But that -- is my description an accurate one of the base case?

[William Mason, Executive VP & Chief Risk Officer]

Yes -- I think I don't -- like an immediate be -- would probably be too optimistic for our scenario. If you look at the Bank of Canada, it wasn't an V, it was more of a U-ish or an L.

[Gabriel Dechaine, Analyst]

Okay. And Liam, while I have you, the performing provision, we bought it by category. I was wondering what it was earmarked to or at least the allowance. Can you tell me geographically, U.S. versus Canada? And how that looks to play?

[William Mason, Executive VP & Chief Risk Officer]

We don't generally comment on breaking out the U.S. that would -- that said, we're very comfortable with the results we're seeing in our NCF portfolio. It's -- in the U.S., it's very diversified across geographies and products. And in Canadian terms, it's -- in terms of the subsegments, as you see, it's driven by commercial largely overall.

[Gabriel Dechaine, Analyst]

Would it be in line with the...

[William Mason, Executive VP & Chief Risk Officer]

There's nothing Alberta -- Gabriel, to stick to your point, there's nothing Alberta-specific. I mean we don't have a lot of exposure to oil and gas, all is done. And our Alberta portfolio, from a mortgage perspective, is largely insured. So there isn't a geographical bias per se.

[Gabriel Dechaine, Analyst]

I'm not really worried about your operating exposure. I'm wondering how much of the performing provision was assigned to Northpoint? Be blunt.

[William Mason, Executive VP & Chief Risk Officer]

We don't generally speak to it, but we're very comfortable with the numbers. What I will say, Gabriel, is that we calibrated those based on what we've seen in terms of losses in similar situations and factored in the government support, and we're very comfortable with the provisions that we have there.

[François Desjardins;President and CEO]

Also, Gabriel, if I may, FD here, ask us to fan to jump in and talk about our NCF business, if I might, because not all geographies are living the pandemic in the same way. Stéphane, you want to jump in here for a second?

[Stéphane Therrien]

Yes. Thank you, François. The -- well, just a -- Northpoint had another great start of the year, obviously, pre-COVID. Again, in the double-digit area. Latest results with Northpoint are showing a higher level of repayment than last year for April, meaning that we are getting reimbursed on units that are sold by the dealer faster than last year, but there's less new advance, less new volume because the manufacturer closed for a couple of weeks and the goods that are -- that we're financing through Northpoint. As a comparison, this morning in the newspaper, there was a great article on BRP, showing that the demand right now in the crisis for these type of goods are quite high. And this is what we're financing. A lot of what we're financing at the Northpoint are the RVs and the boats. So right now, the manufacturing are reopening. They're working at 80% to 100% of their capacity with some challenges. They need to reschedule and reorganize their process. They need to rehire staff in competition with the U.S. government program, and they need to find solution to supply chain issues for parts and materials. But the demand for a lot of what we're financing is close to being back to normal in the state. The RV industry specialists are saying that less travel going forward could mean more RV sales. The same for both. People are redirecting their leisure budget to these type of goods. And this is what we're financing at Northpoint. The inventory of these type of goods, which we'll see and are already seeing a higher demand and which means future growth for us.

[Operator]

We'll now take our next question from Darko Mihelic of RBC Capital Markets.

[Darko Mihelic, MD & Equity Analyst]

A question on -- if you could provide a little more color on the commercial impairments this quarter and the stage 3 losses that you took against it. And as well, just looking at the reserve for your commercial station reserves versus the amount of loans in there? I wonder if you can provide some color on kind of what happened in the quarter there. And provide some idea as to why we should not expect further deterioration of this size?

[William Mason, Executive VP & Chief Risk Officer]

Sure. Darko, thanks for your question. First of all, I just like to talk about how we develop our PCLs. And just when I looked at the analyst calls over the past little while, it seems to be a little question out there as to how the whole process works. And I want to make sure everybody's on the same page. The 2 key areas of change within the -- when you're looking at driving your PCL as most of you know, as the assets migrate across the stages and as you change your economic scenarios, including the waiting on those scenarios. So both of those areas are impacted by COVID and the corresponding impact on the economy. Our approach largely models-based, including the commercial. For the commercial impairments, we have historical parameterization the previous financial crisis, we can adjust those for the government relief programs that went into our models. As we've said, the PCL, other than the specific our reserves was really driven on reserves on performing loans. Our commercial portfolio is not involved in many of the sectors that were challenged. We're not in oil and gas, we're not in hotels, we're not in restaurants. We did a deep dive on the portfolio line by line, and our commercial portfolio continues to perform relatively well. And that's driven by our disciplined underwriting standards. You do have the factor of the Bank of Canada government relief that you're factoring in. But in terms of where we're at right now, as I said, we've calibrated to historical. Large part of it is really against performing assets. And we're comfortable with where we are overall in terms of our provisions.And if the scenarios evolved as expected, we wouldn't -- the reserves are really going to be driven by how those economic situations change in the next quarter and subsequent quarters. And we see things get better, then you'll see the reserves improvement releases and if we don't, you'll see reserves increase. But we're very comfortable with where we are right now, disciplined approach, not in the lot of the other areas and calibrated to what we saw historically adjusted for the government relief.

[Darko Mihelic, MD & Equity Analyst]

Okay. And maybe just to be very specific, I mean, what I'm looking at is really on Page 16 of your supplemental. Specifically, I'm looking at the commercial loans in stage 3, $152.9 million up from $109 million. That's a 40% quarter-over-quarter increase. And so I was just wondering if you can talk to -- we don't typically see that kind of an increase in impaired loans. I'm not talking about the modeling in stage 1 or stage 2. I'm specifically zeroing in on the commercial impairments rising 40% quarter-over-quarter?

[William Mason, Executive VP & Chief Risk Officer]

Yes. We have seen a couple of files that have some challenges on it. We think these are isolated. We had -- we talked last quarter, there were a couple of files this quarter. We've got a couple of files. I don't believe it to be a trend, but we have had a couple of files in 1 or 2 segments that have driven it. I don't think that this is a trend. I think it's more reflective of a combination of weaker files, combined with the COVID impact that have pushed them over the edge in stage 3.

[Operator]

And we will now take our next question from Doug Young of Desjardins Capital Markets.

[Doug Young, Diversified Financials and Insurance Analyst]

Just maybe following on that question. The sequential increase in the commercial loan in stage 1 and 2 provisions and then the stage 3 provisions. Can you maybe talk about -- and then you can kind of build in impairment. Can you talk about it by segment? Like, was it more the inventory finance, equipment finance, commercial real estate or general commercial? Can you just maybe give a little more perspective of what drove the increase in impairments and the increase in the allowances on the commercial side?

[William Mason, Executive VP & Chief Risk Officer]

Well, I can -- I'll have my colleague, Stéphane talk about how the business is evolving, but I don't think there's any one area that stood out in my mind. We saw relatively consistent impacts across the portfolio. I mean the one thing I would say is the strength of our underwriting and collateral positions really do mitigate a lot of the impacts. Remember, 97-plus percent of our portfolio is collateralized. So I wouldn't highlight any one segment as a big driver on the commercial side. If we were talking about the personal side, obviously, unsecured is -- cards is where you see bigger increases. Stéphane, did you want to add anything to that on the commercial?

[Stéphane Therrien]

Yes. Thank you, Liam. Maybe just to add a point on the quality of the portfolio. As our competitors, we offered deferred payments, both in commercial and in personal businesses. And just one point on the overall loan to business customers. Only 10% of our portfolio outstanding right now, so about $1.4 billion asked and were given a moratorium for 3 months. So 10% for us is -- we feel it's a good place to be and it's low.

[Doug Young, Diversified Financials and Insurance Analyst]

And maybe just on the stage 3. like you say, there's a number of files. Was it all in one like category? Was there a particular area or a particular business line that drove that sequential increase in impairments? Because you say there's a few files, what -- we often get from some of the banks just kind of his related hospitality or transportation or whatnot, I think there's some more detail you can give.

[William Mason, Executive VP & Chief Risk Officer]

We don't have -- we don't have a lot in hospitality or transportation. So that's why the big market sectors, we're not in those. So yes...

[Doug Young, Diversified Financials and Insurance Analyst]

So I want you to just give me, like, an example.

[William Mason, Executive VP & Chief Risk Officer]

Yes, yes. No. I get that. These are more specific situations that we're facing some challenges, and I think the COVID situation pushed them over in terms of it. There's been a spillover impact. And if you were weak or we're facing some challenges going into this, then the impact of the COVID has really highlighted and pushed them over the edge.

[Doug Young, Diversified Financials and Insurance Analyst]

Okay. Just François...

[William Mason, Executive VP & Chief Risk Officer]

But it's not. If there was a specific section that I could highlight, I would, but it's not. It's a couple of individual plus.

[Doug Young, Diversified Financials and Insurance Analyst]

Then François, the kind of dividend, you talked about targeting a 40% to 50% payout. Are you suggesting that you simply do the math through these tough times, $0.80 to a $1 is roughly the range in which Laurentian Bank should be operating on a quarterly basis. Is that reasonable?

[François Desjardins;President and CEO]

I think that when we looked at lowering the dividend, it was really as a matter of prudence. As I've said in my previous answer, when we started the year, the target of 40% to 50%, we thought we would earn our way to it. So -- and if COVID wasn't there, it's likely that we would have maintained our course. This is by an abundance of caution. And as I've said day of the year, there's a lot of things that are behind us, but we've struggled with a difficult year in terms of personal customers. I'm seeing early stats despite stabilization, and we're working on growth. As growth comes and efficiency comes, then earnings will come. But I can't really predict the next 6 months. So doing this now, I think is the prudent course. I wouldn't read too much into the level in terms of the future earnings. We will see. I don't know, François, if you want to add additional thoughts?

[François Laurin, Executive VP of Finance, Treasury & CFO]

Thank you, François. I would just add, reiterate what you said earlier, when the pre-COVID there were earning power, earnings that we have was also an indication of where we -- was a touch point in our analysis, Doug.

[François Desjardins;President and CEO]

]Does that help? Does that help your...

[Doug Young, Diversified Financials and Insurance Analyst]

Yes. It just seems like it's too early to tell that it's going to be within that range right now, but that's the range that you brought on a quarterly basis was reasonable, but maybe not over the next few quarters, but as you kind of look through the -- this tough environment. Is that a fair characterization?

[François Laurin, Executive VP of Finance, Treasury & CFO]

There's a -- knowing that COVID, we need to get through COVID as well. So it's very difficult to make any type of projection, guidance on the outcome of the COVID and the impact on the bank's results going forward.

[François Desjardins;President and CEO]

The one thing that I'd like to double back off though, is the work that we're doing on an efficiency side. And as you know, we had talked about the latter half of the year as being better than the first half of the year on expenses. And of course, we've done some work. We've done some additional work. We've released and lowered our headcount. This is work that's ongoing. So expenses is half of the recipe. When we're talking about improving the efficiency ratio, the other half being revenues. So I think that the work ongoing is still there and those positive impacts are going to be felt. But not knowing how the pandemic will play out, it gives us a little bit of reservations about commenting on forecasting.

[Operator]

And we will take our next question from Scott Chan Canaccord Genuity.

[Scott Chan]

Just on the -- the margin was really strong in the quarter on a sequential basis that held up your NII. Maybe can you just talk about the pieces in the quarter and kind of maybe your outlook over the near term?

[François Desjardins;President and CEO]

François Laurin, do you want to comment on that?

[François Laurin, Executive VP of Finance, Treasury & CFO]

Thank you. Thank you, Scott. When compared to sequentially and last year, sequentially, it's up 11 bps. It's basically equally between the higher proportion of the yielding loans to business customers and the lower cost of funding. And that was partially offset by the decrease in the prime/BA spread that we -- everybody lived through in the last quarter. So to give you a sense, a half-half between the 2 impact, 2 elements. And the same thing from Q2 versus last year versus -- year-over-year and Q1-over-Q2. It's the same explanation basically, Scott.

[Scott Chan]

And do you maybe have anything to say on the [ outlook ]?

[François Laurin, Executive VP of Finance, Treasury & CFO]

I'm sorry, I was getting to this. On the outlook, obviously, it's dependent on a variety of factors, as you know, including the volume mix in the second half of the year and all the factors that are adding influence funding costs going forward. However, we remain in a very low interest rate environment, and that could put some modest pressure on NIM in the near future. But it's kind of too early to tell, to provide very clear guidance at this point.

[Scott Chan]

Okay. And just maybe on the payment deferrals on the commercial loans. Can you give us a sense, like if it's concentrated in any particular sector or region? And I assume these are flexible, I guess, like on a one-to-one basis?

[François Desjardins;President and CEO]

Liam, again.

[William Mason, Executive VP & Chief Risk Officer]

Scott, as I previously mentioned, it's not concentrated in any region or sector. These are a few files. We're working through them. In these circumstances, when you have an account that is heading negative, and then you have the compounding effect of COVID, it tends to push them over the edge. We're working through them, but we don't believe this is a trend, and it's not a particular sector or segment. It's just a few files. We're not in the segments that are more challenged.

[François Laurin, Executive VP of Finance, Treasury & CFO]

Scott, there was a part of your question, François Laurin here, on the deferred payments through commercial accounts.

[Scott Chan]

That's right. Yes.

[William Mason, Executive VP & Chief Risk Officer]

Well, in terms of the deferred payments, Stéphane, you want to comment on that?

[Stéphane Therrien]

Yes. Thanks, Scott. Obviously, I said that 10% of our overall business services portfolio is under moratorium right now. In terms of -- it's a bit higher in commercial than in real estate, for example. Commercial is roughly in the 15%, and real estate is very low for so a bit higher than commercial than real estate. That being said, it's -- in real estate, a lot of what we do is construction loan so they -- all they pay is the interest. So obviously, they have not asked for any moratorium. So it's a number, right? But it's not that we'll be revealing the inventory financing is at 19%. But even there, it's not exactly payment because these assets are still up for sales. So what we've done is we offer a program to all our dealers. Generally speaking, they pay for the interest on a monthly basis. And after 6 months, if the unit is not sold, they start reimbursing part of the capital at roughly 2% per month in -- with the help of our manufacturer partner, we offered a new program, whereby the dealer could differ some of these payments for up to 4 months. And right now, 19% of our portfolio is under that. But that being said, again, these units are still up for sale. And as soon as they sell them, they reimburse us. So it's not comparable dollar-for-dollar for a standard commercial loan.

[Scott Chan]

That's helpful. And just lastly, maybe François, you kind of called out kind of special compensation that impacted mix. Is this expected to continue throughout the pandemic?

[François Desjardins;President and CEO]

François Laurin?

[François Laurin, Executive VP of Finance, Treasury & CFO]

Scott, we're reevaluating constantly that position. So we don't make a commitment for long term, but we're evaluating this on a regular basis.

[Operator]

[Operator Instructions] And we will take our next question from Sohrab Movahedi of BMO Capital Markets.

[Sohrab Movahedi, Analyst]

Liam, I just wanted to get a bit of clarification. The commercial stage 3 loans you were talking about. You said -- was it a couple of accounts or more than a couple of accounts?

[William Mason, Executive VP & Chief Risk Officer]

A couple of accounts.

[Sohrab Movahedi, Analyst]

So I mean, $50-ish million increase. I mean are those -- is it fair to say those accounts were on average $25 each?

[William Mason, Executive VP & Chief Risk Officer]

I don't want to comment on the size of the accounts, but I can speak to our commercial limits, which are about $40 million, and it's a couple of accounts.

[Sohrab Movahedi, Analyst]

Okay. And so can you comment how much you've provided against whatever notionals you have up on those 2 accounts?

[William Mason, Executive VP & Chief Risk Officer]

I think we publish our watch list numbers. I'd rather not get into the specifics. We can follow-up with you offline.

[Operator]

And there are no further questions. I'd like to hand it back over to Mr. François Desjardins for closing remarks.

[François Desjardins;President and CEO]

Thank you. This week marks the beginning of our 175th year of operation. We are proud of our history and optimistic about the future. Over the past 174 years, we have seen the invention of cars, planes, computers and mobile devices. We've experienced times of war and peace, lived through market crashes and market booms and now a pandemic. But we've always stayed true to our mission of helping our customers improve their financial health. We will be recognizing this achievement throughout the next year with the slogan Laurentian Bank Financial Group [ there when it counts ] since 1846. Thank you for your time.I will now turn the call back to Susan.

[Susan Cohen, Director of Investor Relations]

Thank you for joining us today. Should you have any further questions, our contact information is included at the end of the presentation. Our third quarter of 2020 conference call will be held on September 4, and we look forward to speaking with you then. Have a great day.

[Operator]

And this concludes today's call. We thank you for your participation. You may now disconnect your lines, and have a wonderful day, everyone.