In July, 2008, as the first sparks of the financial crisis began to fly, Lehman Brothers president Bart McDade told the investment bank's top executive, Richard Fuld, that Lehman was reaching out to Royal Bank of Canada for help.
Although Mr. McDade had no way of knowing it, two months later Lehman, then the fourth-largest investment bank in the United States, would collapse. What he did know was that the beleaguered company needed assistance from a stronger financial institution.
The Canadian bank certainly wasn't the first that Lehman's executives approached. But the answer from RBC's executives was definitive: We have no interest in buying Lehman, nor in making an investment in it.
That's not to say they weren't tempted. RBC's chief executive officer, Gordon Nixon, worked his way up to the company's top job through the ranks of its investment bank and has a strong affinity for that side of the business. But Mr. Nixon is a salesman's nightmare - the type of shopper who would rather buy the pattern and tailor the suit himself than make an off-the-rack purchase.
And, in the aftermath of the meltdown, a funny thing happened: Investment bankers from Lehman and its rivals in the upper echelon of investment banking - who once would have turned up their noses at the thought of working for a Canadian bank - came to RBC asking for a job.
The crisis, for RBC, became a catalyst not to shrink from Wall Street, but to grow. Poaching talent became easier; in the United States alone, RBC's capital markets staff has increased by 24 per cent since 2008, as hundreds of bankers have been added to its ranks. The unit hired about 380 people in Europe just last year and now the bank is ramping up in Asia. Now among the top 12 investment banks globally, ranked by fees, it wants to crack the top 10.
It is an ambitious goal, one that sets RBC apart from other Canadian banks - but not one that is not being greeted with enthusiasm in all quarters.
In December, Moody's Investors Service stripped RBC of its triple-A rating, citing worries that the banks sizable and growing securities business could expose investors to volatility and make it challenging for the bank's executives to manage risk.
"They are one of the firms that's trying to take advantage of the vacuum that was created by the implosion of many U.S. securities firms," said Peter Nerby, a senior vice-president at Moody's.
"Royal is clearly adding people in the U.S., in Europe, and I think has been more explicit that they want to have a global investment banking operation, and we just think that's a tougher thing to manage."
Concerns over the volatility of RBC's investment bank, which makes its money from such activities as selling stock, advising on mergers, and trading, have become a key theme when the bank reports quarterly earnings. Unlike retail banking, capital markets revenue tends to jump around.
When RBC reported second-quarter earnings Friday, the $1.51-billion profit missed Bay Street's expectations by about 10 per cent. The culprit: volatile trading revenue. Turmoil in Europe and the Middle East caused trading revenue to plummet, pushing down profit in the capital markets division by 19 per cent.
"The results this quarter underscore what has been our primary concern on [RBC] earnings volatility," Robert Sedran, an analyst with CIBC World Markets, wrote in a research note Friday.
Speaking on a conference call to discuss the earnings, Mr. Nixon was unapologetic.
"If the earnings were smooth, perhaps the market would like it better," the CEO told analysts. "But unfortunately in that business, we tend to look at it over a longer period of time."
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The volatility question
Before the crisis, Mr. Nixon had already made it clear that he wanted the bank to bring in roughly 25 to 30 per cent of its profit and revenue from capital markets, with the remainder coming from retail banking, a target he maintains. But as the financial crisis swirled, RBC's sales and trading boomed.
"We've gone from before the crisis a business of about $4-billion in revenues, to now a business that is running $6-[billion]ish," said Doug McGregor, chairman and co-CEO of RBC's capital markets business.
"In terms of profitability, it's a business that precrisis was about $1.1-billion to $1.2-billion, now it's sort of $1.6-billion or $1.7-billion. So that's quite a substantial move. And the issue now is, can you make it reliable, sustainable?"
While analysts and investors have been pleasantly surprised by the jump, they fret that trading revenues - which tend to rise when markets are highly volatile - can't be sustained.
Among the Canadian banks, RBC and National Bank of Canada have the highest exposure to capital markets, measured by the amount of bank capital dedicated to that business, Moody's says.
RBC is aware of the perception that it might be too dependent on capital markets revenue. The bank has taken to explaining nuances of its revenue mix to detail why things aren't as volatile as they might seem - noting, for instance, that in the second quarter, trading revenue became a small portion of the business.
Yet, Moody's considers RBC's exposure to be riskier than National Bank's because much of it is outside Canada. Canadian banks have been stung numerous times by their desire to grow abroad, and RBC is no exception. Its U.S. retail bank has proven to be such a money pit that Mr. Nixon is now considering hiving it off, most likely by trading it for a minority stake in a more successful U.S. bank.
But, when it comes to capital markets, RBC thinks it has finally found a formula that will allow a Canadian financial institution to become a major player in the U.S. and elsewhere.
"I'm not saying we're hitting the ball out of the park, but we're really pleased with the way this has gone the last three years," Mr. McGregor said. "I think for the bank it's a very good platform, it's a platform you can just grow."
And as it grows, its image is changing.
Celeste Davis, a municipal finance banker with RBC in San Francisco, knows that some competitors at the so-called "bulge bracket" firms - a term used for the biggest investment banks, such as Goldman Sachs Group Inc. - still thumb their noses at RBC.
"Occasionally I may talk to a competitor who may say something like, 'How does it feel to be at a small regional firm?'" she said.
But that's happening less. When it comes time to convince customers of RBC's heft, she has a new trick. She gets them to visit the 72,000-square-foot trading floor that the Canadian bank built in New York in 2008. One of the largest trading floors on Wall Street, and bigger than those RBC has in Toronto and London, the location was used as a set for the filming of the 2010 movie Wall Street: Money Never Sleeps. And it epitomizes the bank's ambitions.
"If I know a client is going to be in New York for any reason, I will definitely corner them and say 'You've got to take an hour or two and come down to World Financial Centre Three," Ms. Davis said. "Just that visual has helped us tremendously in penetrating some of the largest accounts."
She invited a group from California's state treasury group to tour the trading floor in late 2009. Not long after that, RBC was hired on a medium-sized deal, and it's now working on the largest ones.
RBC's brand has received a substantial boost abroad during the past two years, said National Bank analyst Peter Routledge, as a result of its ability to withstand the credit crisis.
"You're not going to read [Andrew Ross Sorkin's book about the financial crisis] Too Big To Fail and have to look for Royal in the index. They were just bystanders really through the crisis, they stayed away from virtually all the toxic stuff that was going on."
RBC used the period to push its name. Mr. Routledge points to the regular, prominent ads that it placed in the Financial Times, which he believes were geared toward bankers at rival firms. "They were advertising to bankers who were worried about the future. They were saying 'Here we are, the pre-eminent Canadian bank, come aboard.' That creates awareness."
Other measures also helped. Over the past two years, RBC has become a primary dealer in countries such as France and Germany, and, notably, the United States. That lets it into a small group of firms that deal directly with those nations' treasuries to bid in bond auctions.
The prestige that RBC has secured is one reason why Mr. Routledge, for one, isn't too worried about the growth in capital markets. He said it helps to explain why more customers have wanted to trade and do business with the bank.
"If you were a chief risk officer at a pension fund in Europe or an insurance company in Asia, for example, and you were worried about your counterparty exposures, what name would worry you less than Royal Bank of Canada?"
Mark Standish, co-CEO of the business, says the crisis simply allowed RBC to accelerate its hiring and the implementation of its growth plan.
"We're in much better shape today than we've ever been because we have a broader business, from a geographic standpoint, and we have a much deeper business from a product and expertise standpoint."
With that in mind, the business is ramping up its growth in Asia, where it hired more than 100 people last year, bringing its staff in the region to about 350. It opened a new trading floor in Hong Kong in November, doubling its capacity, and it is now creating a new position, head of capital markets in Asia.
Mr. Standish believes that as new capital and funding rules for banks come into effect, there will be another industry shakeout - and another opportunity to grow.
"We've been building this thing very carefully and in a very disciplined way and, yeah, we got a big boost from what was a very tragic period of time - and for many people still is quite tragic. But it's given us a momentum that we're enjoying."
Mr. Nerby of Moody's remains unconvinced. "One of the great challenges is both the opacity of risk and how quickly risk can change at any investment bank, including the Royal Bank of Canada, and that remains a problem," he said.
So, for now, the fast growth in RBC's capital markets business is acting as a drag on the bank's stock price because investors are worrying about it, Mr. Routledge said.
He doesn't see the bank's exposure to capital markets shrinking any time soon. There's not that much room for growth in Canadian retail banking; U.S. retail banking is likely to get smaller, not bigger.
That means the bank's stock price will continue to be penalized for the near future, Mr. Routledge added.
"The U.S. has to wrestle with its budgetary issues and debt ceiling, you've got Europe still dealing with Greece and Portugal and Ireland, and those are big issues to resolve. And until they do, there's going to be a lot of uncertainty, and that will depress capital markets revenues.
"We'll come out of it, and RBC will be a much stronger bank. They're making headway, but the reward will be delayed."
Grant Robertson