EX-2 3 o38519exv2.htm EX-2 exv2
 

EXHIBIT 2
Management’s Discussion and Analysis
Management’s discussion and analysis (MD&A) is provided to enable a reader to assess our results of operations and financial condition for the fiscal year ended October 31, 2007, compared to the preceding two years. This MD&A should be read in conjunction with our Consolidated Financial Statements and related notes and is dated November 29, 2007. All amounts are in Canadian dollars, unless otherwise specified, and are based on financial statements prepared in accordance with Canadian generally accepted accounting principles (GAAP). Effective October 31, 2006, RBC Mortgage Company disposed of substantially all of its remaining assets and obligations and we no longer separately classify its results in our Consolidated Financial Statements. Results reported on a total consolidated basis are comparable to results reported from continuing operations for the corresponding prior periods.
Additional information about us, including our 2007 Annual Information Form, is available free of charge on our website at rbc.com/investorrelations, on the Canadian Securities Administrators’ website at sedar.com and on the EDGAR section of the United States Securities and Exchange Commission’s (SEC) website at sec.gov.
34   Overview
  34   About Royal Bank of Canada
 
  34   Vision and strategic goals
 
  35   Selected financial and other highlights
 
  36   Overview of 2007
  38   Outlook and objectives for 2008
38   Accounting and control matters
 
  38   Critical accounting policies and estimates
 
  42   Future changes in accounting policies
 
  42   Controls and procedures
43   Financial performance
 
  43   Overview
 
  45   Total revenue
 
  46   Net interest income and margin
 
  47   Change in net interest income
 
  47   Non-interest expense
 
  48   Provision for credit losses
 
  48   Insurance policyholder benefits, claims and acquisition expense
 
  49   Taxes
 
  50   Results by geographic segment
 
  50   Related party transactions
51   Quarterly financial information
  51   Results and trend analysis
 
  52   Fourth quarter 2007 performance
 
53   Business segment results
 
  54   How we measure and report our business segments
 
  55   Impact of foreign exchange rates on our business segments
 
  55   Key performance and non-GAAP measures
 
  57   Canadian Banking
 
  61   Wealth Management
 
  64   U.S. & International Banking
 
  67   Capital Markets
 
  70   Corporate Support
71   Financial condition
  71   Balance sheet
 
  71   Capital management
 
  77   Off-balance sheet arrangements
80   Risk management
  83   Overview
 
  83   Credit risk
 
  92   Market risk
 
  95   Operational risk
 
  96   Liquidity and funding risk
 
  99   Reputation risk
 
  99   Regulatory and legal risk
 
  100   Environmental risk
 
  101   Insurance risk
 
  101   Strategic risk
 
  102   Competitive risk
 
  102   Systemic risk
102   Additional risks that may affect future results
 
104   Additional financial information
See our Glossary for definitions of terms used throughout this document
Caution regarding forward-looking statements
From time to time, we make written or oral forward-looking statements within the meaning of certain securities laws, including the “safe harbour” provisions of the United States Private Securities Litigation Reform Act of 1995 and any applicable Canadian securities legislation. We may make forward-looking statements in this document, in other filings with Canadian regulators or the United States Securities and Exchange Commission, in reports to shareholders and in other communications. Forward-looking statements include, but are not limited to, statements relating to our medium-term and 2008 objectives, our strategic goals and priorities and the economic and business outlook for us, for each of our business segments and for the Canadian, United States and international economies. Forward-looking statements are typically identified by words such as “believe,” “expect,” “forecast,” “anticipate,” “intend,” “estimate,” “plan” and “project” and similar expressions of future or conditional verbs such as “will,” “may,” “should,” “could,” or “would.”
     By their very nature, forward-looking statements require us to make assumptions and are subject to inherent risks and uncertainties, which give rise to the possibility that our predictions, forecasts, projections, expectations or conclusions will not prove to be accurate, that our assumptions may not be correct and that our objectives, strategic goals and priorities will not be achieved. We caution readers not to place undue reliance on these statements as a number of important factors could cause our actual results to differ materially from the expectations expressed in such forward-looking statements. These factors include credit, market, operational, liquidity and funding risks, and other risks discussed in our 2007 management’s discussion and analysis; general business and economic conditions in Canada, the United States and other countries in which we conduct business, including the impact from the continuing volatility in the U.S. subprime and related markets and lack of liquidity in various of the financial markets; the impact of the movement of the Canadian dollar relative to other currencies, particularly the U.S. dollar, British pound and Euro; the effects of changes in government monetary and other policies; the effects of competition in the markets in which we operate; the impact of changes in laws and regulations; judicial or regulatory judgments and legal proceedings; the accuracy and completeness of information concerning our clients and counterparties; our ability to successfully execute our strategies and to complete and integrate strategic acquisitions and joint ventures successfully; changes in accounting standards, policies and estimates, including changes in our estimates of provisions and allowances; and our ability to attract and retain key employees and executives.
     We caution that the foregoing list of important factors is not exhaustive and other factors could also adversely affect our results. When relying on our forward-looking statements to make decisions with respect to us, investors and others should carefully consider the foregoing factors and other uncertainties and potential events. Unless required by law, we do not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by us or on our behalf.
     Additional information about these and other factors can be found under the Risk management section that may affect future results section and the Additional risks that may affect future results section.
 
Information contained in or otherwise accessible through the websites mentioned does not form part of this document. All references in this document to websites are inactive textual references and are for your information only.
     
  Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 33

 

 

OVERVIEW
About Royal Bank of Canada
Royal Bank of Canada (RY on TSX and NYSE) and its subsidiaries operate under the master brand name of RBC. We are Canada’s largest bank as measured by assets and market capitalization and one of North America’s leading diversified financial services companies. We provide personal and commercial banking, wealth management services, insurance, corporate and investment banking and transaction processing services on a global basis. We employ more than 70,000 full- and part-time employees who serve more than 15 million personal, business, public sector and institutional clients through offices in Canada, the U.S. and 36 other countries.
     Effective February 7, 2007, our previous three business segments (RBC Canadian Personal and Business, RBC U.S. and International Personal and Business, and RBC Capital Markets) were reorganized into four business segments:
     Canadian Banking comprises our domestic personal and business banking operations, certain retail investment businesses and our global insurance operations.
     Wealth Management comprises businesses that directly serve the growing wealth management needs of affluent and high net worth clients in Canada, the U.S. and outside North America, and businesses that provide asset management and trust products through RBC and external partners.
     U.S. & International Banking comprises our banking businesses outside Canada, including our banking operations in the U.S. and Caribbean. In addition, this segment includes our 50% ownership in RBC Dexia Investor Services (RBC Dexia IS).
     Capital Markets comprises our global wholesale banking business, which provides a wide range of corporate and investment banking, sales and trading, research and related products and services to corporations, public sector and institutional clients in North America, and specialized products and services in select global markets.
     Our business segments are supported by our Corporate Support team, which consists of Global Technology and Operations (GTO) and Global Functions. GTO provides the operational and technological foundation required to effectively deliver products and services to our clients. It also leads innovative process and technology improvements intended to maintain the safety and soundness of our operations, while keeping our capabilities ahead of the competition. Our Global Functions team of professionals provides sound governance and advice in the areas of risk, compliance, law, finance, tax and communications. This team also manages the capital, and liquidity and funding positions of the enterprise to ensure that we meet regulatory requirements, while ensuring effective funding management and allocation of capital. In addition, the Global Functions team provides support to our people and manages relationships with external stakeholders, including investors, credit rating agencies and regulators, as well as supports strategic business decisions.
(CORPORATE CHART)
Vision and strategic goals
Our business strategies and actions are guided by our vision of “Always earning the right to be our clients’ first choice.” We believe that this client-focused approach to our business is critical to achieving our strategic as well as our financial performance goals. Our Client First philosophy is exhibited in all of our activities, including how we deal with our clients, develop our products and services, and collaborate across businesses and functions. We maintain our focus on enhancing client satisfaction and loyalty by continually striving to understand and meet the evolving needs and expectations of our clients. We believe that pursuing our vision will generate strong, stable revenue and earnings growth that will result in top quartile total shareholder return compared to our North American peer group.
     The Canadian market continues to provide us with significant avenues for growth in both the retail and wholesale sectors. Our trusted brand, together with our broad expertise and leading positions in diverse financial products and services, provides us with the foundation and resources to expand internationally. The U.S., with its geographic proximity, cultural similarities and close trade relationships with Canada, will continue to be a focus of future growth as we build on our strong market positions in selected businesses. In addition, we will continue to expand outside North America in markets where our experience and expertise provide us with the ability to compete effectively.
     For 2008, our strategic goals are to remain focused on growing our domestic franchise, while continuing to expand internationally by leveraging our core capabilities and by building on our portfolio of international businesses. We expect to achieve these goals by maintaining our focus on meeting the needs of clients through ongoing innovation and by collaborating effectively across our many businesses and functions.
•   In Canada, our goal is to be the undisputed leader in financial services. We are strengthening the RBC brand by delivering a superior client experience with a comprehensive suite of quality financial products and services for all our clients. In banking, we continue to leverage our extensive distribution capabilities to grow market share across products and markets, while expanding and enhancing our distribution network to meet the needs of our clients. We are also developing innovative solutions and simplifying processes for our clients to make it easier for them to do business with us. In wealth management, we continue to extend our lead in wealth and asset management markets and to attract and retain experienced advisors. In capital markets, we continue to focus on maintaining our leadership position across all businesses and remain our wholesale clients’ first choice for all financial products and services.
 
•   In the United States, our goal is to build on our strengths in banking, wealth management and capital markets. In banking, we are focused on meeting the needs of businesses, business owners and professionals. We continue to expand our U.S. Southeast footprint in key high-growth markets through targeted de novo branch openings and strategic acquisitions. In wealth management, we continue to expand our business through organic growth and strategic acquisitions, and provide our advisors with
     
Royal Bank of Canada: Annual Report 2007
34 Management’s Discussion and Analysis

 

 

    customized support for investment, advisory and wealth management practices by utilizing our global resources. In capital markets, we continue to deepen the penetration of our existing client base through diverse product offerings and leveraging the strengths of recent acquisitions, and enhancing our origination capabilities to expand our client base.
 
•   Outside North America, our goal is to be a premier provider of selected financial services where our core capabilities and key expertise provide us with competitive advantages. In banking, we intend to continue to build on our strong position in the Caribbean through strategic acquisitions and organic growth, supported by ongoing operational improvements, strengthening of client relationships and broadening of product offerings. In wealth management, our strategy remains focused on increasing scale through expansion in our chosen markets and recruiting relationship managers. We will continue to make targeted acquisitions and enhance the breadth of our products and services, as well as improve our relationship management model to capitalize on the growing demand for wealth management products and services. In custody services, our joint venture, RBC Dexia IS, utilizes its global scale and expanded product capability to grow the number of and deepen our client relationships. In capital markets, we continue to expand our global distribution and extend our capabilities in structuring and trading businesses, infrastructure finance and fixed income origination.
     Guided by our Client First philosophy and strategic goals, our business segments continue to tailor their strategies to meet client needs and strengthen client relationships within their unique operating and competitive environments. We believe that the successful execution of our business strategies will enhance the quality and diversity of our earnings. These efforts should result in the continued strong market leadership of our Canadian businesses as well as improved results and solid growth in our U.S. and international businesses.
     
Selected financial and other highlights   Table 1
                                         
                              2007 vs. 2006  
(C$ millions, except per share, number of and percentage amounts)   2007     2006     2005     Increase (decrease)
 
Total revenue
   $ 22,462     $ 20,637     $ 19,184     $ 1,825       8.8 %
Non-interest expense
     12,473       11,495       11,357       978       8.5 %
Provision for credit losses
     791       429       455       362       84.4 %
Insurance policyholder benefits, claims and acquisition expense
     2,173       2,509       2,625       (336 )     (13.4 )%
Net income before income taxes and non-controlling interest in subsidiaries
     7,025       6,204       4,702       821       13.2 %
Net income from continuing operations
     5,492       4,757       3,437       735       15.5 %
Net loss from discontinued operations
     —       (29 )     (50 )     29       n.m.  
Net income
   $ 5,492     $ 4,728     $ 3,387     $ 764       16.2 %
 
Segments — net income
                                        
Canadian Banking
   $ 2,987     $ 2,426     $ 2,007     $ 561       23.1 %
Wealth Management
     762       604       502       158       26.2 %
U.S. & International Banking
     242       261       256       (19 )     (7.3 )%
Capital Markets
     1,292       1,355       686       (63 )     (4.6 )%
Corporate Support
     209       111       (14 )     98       n.m.  
Net income
   $ 5,492     $ 4,757     $ 3,437     $ 735       15.5 %
 
Selected information
                                        
Earnings per share (EPS) — basic
   $ 4.24     $ 3.65     $ 2.61     $ .59       16.2 %
Earnings per share (EPS) — diluted
   $ 4.19     $ 3.59     $ 2.57     $ .60       16.7 %
Return on common equity (ROE) (1)
     24.6 %     23.5 %     18.0 %     n.m.     110 bps
Return on risk capital (RORC) (2)
     37.4 %     36.7 %     29.3 %     n.m.       70 bps
Net interest margin (3)
     1.30 %     1.35 %     1.53 %     n.m.       n.m.  
Capital ratios (4)
                                        
Tier 1 capital ratio
     9.4 %     9.6 %     9.6 %     n.m.       (20) bps
Total capital ratio
     11.5 %     11.9 %     13.1 %     n.m.       (40) bps
Selected balance sheet and other information
                                        
Total assets
   $ 600,346     $ 536,780     $ 469,521     $ 63,566       11.8 %
Securities
     178,255       184,869       160,495       (6,614 )     (3.6 )%
Retail loans
     169,462       151,050       140,239       18,412       12.2 %
Wholesale loans
     69,967       58,889       51,675       11,078       18.8 %
Deposits
     365,205       343,523       306,860       21,682       6.3 %
Average common equity (1)
     22,000       19,900       18,600       2,100       10.6 %
Average risk capital (2)
     14,450       12,750       11,450       1,700       13.3 %
Risk-adjusted assets (4)
     247,635       223,709       197,004       23,926       10.7 %
Assets under management
     161,500       143,100       118,800       18,400       12.9 %
Assets under administration — RBC
     548,200       525,800       1,778,200       22,400       4.3 %
— RBC Dexia IS (5)
     2,713,100       2,421,100       —       292,000       12.1 %
Common share information
                                        
Shares outstanding (000s) — average basic
     1,273,185       1,279,956       1,283,433       (6,771 )     (.5 )%
— average diluted
     1,289,314       1,299,785       1,304,680       (10,471 )     (.8 )%
— end of period
     1,276,260       1,280,890       1,293,502       (4,630 )     (.4 )%
Dividends declared per share
   $ 1.82     $ 1.44     $ 1.18     $ .38       26.4 %
Dividend yield
     3.3 %     3.1 %     3.2 %     n.m.       20 bps
Common share price (RY on TSX) — close, end of period
   $ 56.04     $ 49.80     $ 41.67     $ 6.24       12.5 %
Market capitalization (TSX)
     71,522       63,788       53,894       7,734       12.1 %
Business information (number of)
                                        
Employees (full-time equivalent)
     65,045       60,858       60,012       4,187       6.9 %
Bank branches
     1,541       1,443       1,419       98       6.8 %
Automated teller machines
     4,419       4,232       4,277       187       4.4 %
 
Period average US$ equivalent of C$1.00 (6)
   $ .915     $ .883     $ .824     $ .03       4 %
Period-end US$ equivalent of C$1.00
     1.059       .890       .847       .17       19 %
 
(1)   Average common equity and Return on common equity are calculated using month-end balances for the period.
 
(2)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. For further discussion on Average risk capital and Return on risk capital, refer to the Key performance and non-GAAP measures section.
 
(3)   Net interest margin (NIM) is calculated as Net interest income divided by Average assets. Average assets are calculated using methods intended to approximate the average of the daily balances for the period.
 
(4)   Calculated using guidelines issued by the Office of the Superintendent of Financial Institutions Canada (OSFI).
 
(5)   Assets under administration — RBC Dexia IS represents the total Assets under administration (AUA) of the joint venture as at September 30, 2007. We have revised the 2006 amount to reflect the amount reported by RBC Dexia IS, as we had previously disclosed only the assets under custody amount related to our joint venture.
 
(6)   Average amounts are calculated using month-end spot rates for the period.
 
n.m.   not meaningful
     
  Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 35

 

 

Overview of 2007
We reported record net income of $5,492 million for the year ended October 31, 2007, up $764 million, or 16%, from a year ago. Diluted earnings per share (EPS) were $4.19, up 17% compared to a year ago. ROE was 24.6%, compared to 23.5% a year ago. The Tier 1 capital ratio of 9.4% was down 20 basis points (bps) from 9.6% a year ago, while our Total capital ratio of 11.5% was down 40 bps from 11.9% a year ago.
Executing our initiatives
During the year, we continued to diversify our products and services, markets, and geographical presence to generate strong and stable earnings growth. We remained focused on strengthening our distribution capabilities and enhancing client satisfaction and loyalty, while seeking to deliver top quartile total shareholder return versus our North American peer group.
     In Canada, we continued to strengthen our leadership position in most major product categories by enhancing the quality and breadth of our products and services, as well as expanding and upgrading our distribution network to better serve our clients. We continued to be the leader in the Canadian mutual fund industry in terms of net long-term sales and in most of our capital market businesses. We also strengthened our leadership positions in most product categories, including mortgages, credit cards and business loans and deposits. As part of our initiatives to meet client needs and build enduring client relationships, we have expanded our distribution capabilities by adding new bank branches, insurance offices and automated teller machines particularly in high-growth markets, and have upgraded our branches. We launched new and innovative products, including a high-interest online savings account and socially responsible mutual funds. We have also continued to streamline sales, credit and back-office processes to make it easier for our clients to do business with us. Our trusted brand, together with our leadership position in most major product categories in Canada, continued to provide us with the foundation and resources to expand internationally.
     In the U.S., we continued to build scale and capability in all our major businesses through a combination of organic growth and strategic acquisitions. To expand our banking capabilities strategically in high-growth markets in the U.S. Southeast, we completed the acquisition of Atlanta-based Flag Financial Corporation and 39 AmSouth Bank branches in Alabama. These acquisitions, which complemented our de novo branch openings, have significantly expanded our banking presence in the U.S. Southeast. We also announced an agreement (1) to acquire Alabama National BanCorporation, the parent of 10 subsidiary banks and other affiliated businesses in Alabama, Florida and Georgia, which will add another 103 branches and strengthen our retail distribution by growing our footprint to over 450 locations throughout high-growth southeastern U.S. markets. We also expanded our investment banking and wealth management capabilities in the U.S. We completed the acquisition of Carlin Financial Group, which provides our clients with a best-in-class North American electronic trade execution platform. We completed the acquisition of Daniels & Associates, L.P., a leading mergers and acquisitions advisory firm specializing in the communications, media and entertainment, and technology sectors. In addition, we completed the acquisition of Seasongood & Mayer, LLC, strengthening our franchise as one of the leading municipal finance platforms in the U.S. We also completed the acquisition of J.B. Hanauer & Co., expanding our retail fixed income and wealth management capabilities in New Jersey, Florida and Pennsylvania.
     Internationally, we strategically expanded our distribution network, products and services in fast-growing markets and regions. During the year, we announced our intention to acquire RBTT Financial Group (RBTT) to expand our banking footprint in the Caribbean. The acquisition is expected to close by the middle of 2008 (1), and will create one of the most extensive retail banking networks in the Caribbean, with a presence in 18 countries and territories across the region. We also announced our intention to acquire a 50% interest in Fidelity Merchant Bank & Trust Limited, the Bahamas-based wholly owned subsidiary of Fidelity Bank & Trust International Limited to form a joint venture to be called Royal Fidelity Merchant Bank & Trust Limited, which is expected to close in the first quarter of 2008 (1). This pending acquisition is expected to extend our growing financial services platform in the Caribbean and will enable us to have greater access to the fast-growing merchant banking and corporate advisory sector in the region.
Basel II
As of November 1, 2007, we implemented the International Convergence of Capital Measurement and Capital Standards: A Revised Framework – Comprehensive Version (June 2006), known as Basel II. Basel II more closely aligns regulatory capital requirements with a financial institution’s underlying risk profile and internal risk management practices as compared to Basel I, and is intended to ensure that our capital holdings adequately underpin those risks. For details related to the implications of Basel II on our capital management framework and risk measurement approaches, refer to the Capital management and Risk management sections.
2007 Economic and market review
In 2007, the Canadian economy grew at an estimated rate of 2.6%, which was down slightly from the 2.7% projected a year ago, with domestic demand remaining the key driver of economic growth. Robust economic growth in the early part of the year, largely reflecting strong consumer spending underpinned by strong labour market conditions, solid business investment, favourable terms of trade and solid housing market activities, weakened slightly in the latter part of the year. This was mainly attributable to slowing U.S. demand and a tightening of credit conditions as a result of the U.S. subprime mortgage market concerns. While growth of both consumer and business lending largely remained solid, credit quality weakened moderately during the year as conditions appeared to be reverting to historical averages. The Bank of Canada raised the overnight rate by 25 bps in July to 4.5%, and kept the rate unchanged in September and October taking into account the tightening of credit conditions arising from the U.S. subprime mortgage market concerns and the marked appreciation of the Canadian dollar, which had a negative impact on net exports. To address the liquidity concerns and to support the efficient functioning of the Canadian financial system, the Bank of Canada injected liquidity into the financial markets on a number of occasions over the latter part of the year.
     The U.S. economy grew at an estimated rate of 2% for the year, down from the 2.6% projected in 2006. This downward revision to growth was primarily attributable to the U.S. subprime mortgage market concerns. Solid economic growth in the middle of the year, primarily supported by continued non-residential investment, strong export growth and still-solid consumer spending, slowed in the latter part of the year. The weakened economic growth was largely a result of slowing residential investment amid the ongoing housing market correction, a tightening of credit conditions and increased funding costs arising from the U.S. subprime mortgage market concerns, as well as a general repricing of risk in numerous markets. Consumer and business lending, excluding mortgages, accelerated over recent months, although there remained concerns that the intensification of the housing market correction would eventually dampen lending. Credit quality weakened, particularly in high-risk credit products and residential real estate-related loans. To alleviate the mounting liquidity
(1)   These acquisitions are subject to customary closing conditions including regulatory and shareholder approvals.
Royal Bank of Canada: Annual Report 2007
36 Management’s Discussion and Analysis

 

 

concerns and to ease the U.S. financial market volatility arising from the U.S. subprime mortgage market difficulties, the U.S. Federal Reserve injected a significant amount of liquidity into financial markets beginning in August. It then lowered its federal funds rate by 50 bps and 25 bps in September and October, respectively, to 4.5%, in an effort to promote economic growth, forestall a severe economic downturn and alleviate liquidity concerns.
     Growth in other global economies remained solid for the year. Although central banks in the United Kingdom, the Eurozone and Japan had indicated their intention to further increase interest rates to contain inflationary pressures in the early part of the year, they had put their tightening monetary policies on hold to avoid an economic slowdown, taking into account the financial market volatility triggered by U.S. subprime mortgage market concerns.
     Compared to our favourable outlook in 2006, global capital market conditions were mixed during the year, largely attributable to the U.S. subprime mortgage market concerns. Most major equity markets reached record highs in June and July, and then declined as did the debt markets, except for government bonds, largely due to the spillover effects of the U.S. subprime mortgage market difficulties. Debt and equity origination activities, which were strong at the beginning of the year, slowed due to less favourable pricing and a tightening of liquidity. Merger and acquisitions (M&A) activity remained strong for most of the year.
     
2007 Performance vs. objectives   Table 2
                 
    2007     2007  
    Objectives     Performance  
 
Diluted earnings per share (EPS) growth
     10 %+     17 %
Defined operating leverage (1)
     >3 %     2.6 %
Return on common equity (ROE)
     20 %+     24.6 %
Tier 1 capital ratio (2)
     8 %+     9.4 %
Dividend payout ratio
     40%–50 %     43 %
 
(1)   Our defined operating leverage refers to the difference between our revenue growth rate (as adjusted) and non-interest expense growth rate (as adjusted). Revenue is based on a taxable equivalent basis and excludes consolidated Variable interest entities (VIEs), accounting adjustments related to the new financial instruments accounting standards and Global Insurance revenue. Non-interest expense excludes Global Insurance expense. This is a non-GAAP measure. For further information including a reconciliation, refer to the Key performance and non-GAAP measures section.
 
(2)   Calculated using guidelines issued by the OSFI.
2007 Annual objectives
Our diluted EPS growth, ROE and dividend payout ratio compared favourably to our annual objectives, largely reflecting strong performance across most of our businesses. We also increased our dividend by $.38, or 26%, in 2007. Our defined operating leverage ratio was below our annual objective, reflecting higher costs in support of our growing business as well as investment in future growth initiatives including acquisitions. Our capital position remained strong, with a Tier 1 capital ratio comfortably above our target.
Medium-term objective
Our medium-term objective is to achieve top quartile (1) total shareholder return (TSR) compared to our Canadian and U.S. peers. This medium-term objective increases our focus on our priority to maximize shareholder value and requires us to consider both our current performance and our investment in higher return businesses that will provide sustainable competitive advantage and stable earnings growth.
     Our three-year average annual TSR (2) of 25% ranks us in the top quartile compared to our peer group and compares favourably with the three-year average annual TSR for our peer group of 8%. Our performance reflects our strong financial results, including returns on our investment in our businesses, and effective risk and capital management, which has allowed us to successfully meet most of our annual earnings and capital objectives over the last three years.
     Our five-year average annual TSR (2) of 19% ranks us in the second quartile against our peer group. This compares favourably with the five-year average annual TSR for our peer group of 14%.
     Dividends paid over the three-year period have increased at an average annual compounded rate of 22%.
 
(1)   Versus the TSR of seven large Canadian financial institutions (Manulife Financial Corporation, The Bank of Nova Scotia, Toronto-Dominion Bank, Bank of Montreal, Sun Life Financial Inc., Canadian Imperial Bank of Commerce and National Bank of Canada) and 13 U.S. financial institutions (Bank of America Corporation, JPMorgan Chase & Co., Wells Fargo & Company, Wachovia Corporation, U.S. Bancorp, SunTrust Banks, Inc., The Bank of New York Mellon Corporation, BB&T Corporation, Fifth Third Bancorp, National City Corporation, The PNC Financial Services Group, Inc., KeyCorp and Northern Trust Corporation).
 
(2)   The three-year average annual TSR is calculated based on share price appreciation plus reinvested dividend income for the period October 31, 2004 to October 31, 2007. The five-year average annual TSR is calculated based on the period October 31, 2002 to October 31, 2007.
(BAR CHART)
(BAR CHART)
(1)   For Canadian financial institutions, the Canadian dollar is used. For U.S. financial institutions, the U.S. dollar is used.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  37

 

 

Outlook and objectives for 2008
Economic outlook
Economic growth in Canada is expected to weaken as a strong Canadian dollar and sluggish U.S. growth weigh on export growth. Nonetheless, continued favourable terms of trade should support income growth, which in turn should help sustain business and consumer spending. We expect the Bank of Canada to decrease interest rates by 50 bps by early 2008, taking into account the intensifying restraint from the trade sector before shifting to a rising interest rate environment in late 2008 when financial market volatility is expected to dissipate. We forecast that the Canadian dollar will remain elevated against the U.S. dollar into early 2008, reflecting firm commodity prices, solid global economic growth and broad-based U.S. dollar weakness. Taking into account modest U.S. growth, a strong Canadian dollar and a tightening of credit conditions, we expect the Canadian economy to grow at 2.2% in 2008.
     We anticipate that the U.S. financial market volatility will persist into early 2008 as investors and lenders will remain cautious and risk averse amid a slowdown in the housing market. U.S. economic growth is expected to accelerate in the latter part of 2008, primarily underpinned by rising business investment, strong export growth boosted by the relatively weak U.S. dollar, as well as continued consumer spending reflecting solid personal disposable income and healthy household balance sheets against a backdrop of lower interest rates, and the abatement of current financial market volatility and the housing market correction. We project that the U.S. Federal Reserve will decrease the federal funds rate a further 75 bps by early 2008 to insure that the downside risks from the financial market turmoil are contained, and will start to increase the rate in the latter part of 2008 when economic growth is expected to accelerate. We project that the U.S. economy will grow at 2.2% in 2008, taking into account anticipated improving economic conditions in the latter part of the year.
     Growth in other global economies is expected to ease moderately in 2008, with the highest growth projected for China and other emerging Asian economies. Economic growth in Japan and the Eurozone is anticipated to weaken slightly on moderately slowing investment related to tighter credit conditions and modest U.S. growth, although it should remain solidly supported by continued business and household spending.
Business outlook
Although consumer lending growth is expected to moderate in 2008 on tighter credit conditions, growth should continue to be supported by rising domestic demand amid expanding labour markets. The introduction of new mortgage products in Canada due to the liberalization of the mortgage insurance market should also continue to underpin credit growth. We anticipate business lending to remain solid with ongoing investment spending. While credit quality is projected to weaken moderately, we expect consumer and business credit quality to remain solid in a historical context, with an anticipated increase in provision for credit losses primarily resulting from modestly higher average delinquency rates, portfolio growth and lower recoveries.
     Capital market conditions are anticipated to improve from the challenging environment over the latter part of 2007 stemming from the U.S. subprime mortgage market concerns. Liquidity concerns should also abate as global financial markets stabilize and gradually return to more normalized levels of activity. We expect a rebound in underperforming businesses as strains in financial markets ease.
2008 Objectives
Our primary financial objective continues to focus on providing top quartile TSR relative to our North American peers. This medium-term objective requires our focus on both current performance as well as prudent investment in higher return businesses that will provide us with competitive advantages and stable earnings growth for the future.
 
2008 Objectives   Table 3
         
Diluted earnings per share (EPS) growth
     7%-10 %
Defined operating leverage (1)
     >3 %
Return on common equity (ROE)
     20% +
Tier 1 capital ratio (2)
     8% +
Dividend payout ratio
     40%-50 %
 
(1)   Our defined operating leverage is a non-GAAP measure and refers to the difference between our revenue growth rate (as adjusted) and non-interest expense growth rate (as adjusted).
 
(2)   Calculated using guidelines issued by the OSFI under Basel II, which changes the methodology for the determination of risk-adjusted assets (RAA) and regulatory capital.
For 2008, our financial objectives have been established taking into consideration our three strategic goals and our economic and business outlooks as outlined in this section. Objectives for our defined operating leverage, ROE, Tier 1 capital ratio and dividend payout ratio remain unchanged, reflecting our continued commitment to strong revenue growth and cost containment, as well as sound and effective management of capital resources. Our 2008 diluted EPS growth objective is 7% to 10%. Our objectives factor in the effect of our pending acquisitions of ANB and RBTT, which will be funded partly through issuance of our common shares, as well as the related integration costs.
Accounting and control matters
Critical accounting policies and estimates
Application of critical accounting policies and estimates
Our significant accounting policies and estimates are described in Note 1 to our Consolidated Financial Statements. Certain of these policies, as well as estimates made by management in applying such policies, are recognized as critical because they require us to make particularly subjective or complex judgments about matters that are inherently uncertain and because of the likelihood that significantly different amounts could be reported under different conditions or using different assumptions. Our critical accounting policies and estimates relate to the allowance for credit losses, fair value of financial instruments, other-than-temporary impairment of available-for-sale and held-to-maturity securities, securitization, variable interest entities, pensions and other post-employment benefits and income taxes. Our critical accounting policies and estimates have been reviewed and approved by our Audit Committee, in consultation with management, as part of their review and approval of our significant accounting policies and estimates.
Allowance for credit losses
The allowance for credit losses represents management’s estimate of identified credit related losses in the portfolio, as well as losses that have been incurred but are not yet identifiable at the balance sheet date. The allowance is established to cover the lending portfolio including loans, acceptances, letters of credit and guarantees, and unfunded commitments. The allowance for credit losses comprises the specific allowance and the general allowance. The specific allowance is
Royal Bank of Canada: Annual Report 2007
38 Management’s Discussion and Analysis

 

 

determined through management’s identification and determination of losses related to impaired loans. The general allowance is determined on a quarterly basis through management’s assessment of probable losses in the remaining portfolio.
     The process for determining the allowances involves quantitative and qualitative assessments using current and historical credit information. Our lending portfolio is reviewed on an ongoing basis to assess whether any borrowers should be classified as impaired and whether an allowance or write-off is required. The process inherently requires the use of certain assumptions and judgments including: (i) assessing the impaired status and risk ratings of loans; (ii) estimating cash flows and collateral values; (iii) developing default and loss rates based on historical and industry data; (iv) adjusting loss rates and risk parameters based on the relevance of historical loss rate given changes in credit strategies, processes and policies; (v) assessing the current credit quality of the portfolio based on credit quality trends in relation to impairments, write-offs and recoveries, portfolio characteristics and composition; and (vi) determining the current position in the economic and credit cycles. Changes in these assumptions or using other reasonable judgments can materially affect the allowance level and thereby our net income.
Specific allowances
Specific allowances are established to cover estimated losses on both retail and wholesale impaired loans. Loan impairment is recognized when, based on management’s judgment, there is no longer reasonable assurance that all interest and principal payments will be made in accordance with the loan agreement.
     For wholesale portfolios including small business loans managed individually, which are continuously monitored, an account is classified as impaired based on our evaluation of the borrower’s overall financial condition, its available resources and its propensity to pay amounts as they come due. A specific allowance is then established on individual accounts that are classified as impaired, using management’s judgment relating to the timing of future cash flow amounts that can be reasonably expected from the borrower, financially responsible guarantors and the realization of collateral. The amounts expected to be recovered are reduced by estimated collection costs and discounted at the effective interest rate of the obligation.
     For retail portfolios managed on a pooled basis, including residential mortgages and personal and small business loans, accounts are classified as impaired based on contractual delinquency status, generally 90 days past due. The estimation of specific allowance on these accounts is based on formulas that apply product-specific net write-off ratios to the related impaired amounts. The net write-off ratios are based on historical loss rates, adjusted to reflect management’s judgment relating to recent credit quality trends, portfolio characteristics and composition, and economic and business conditions. Credit card balances are directly written off after payments are 180 days past due. Personal loans are generally written off at 150 days past due.
General allowance
The general allowance is established to cover estimated credit losses that are incurred in the lending portfolio that have not yet been specifically identified as impaired. This estimation is based on a number of assumptions including: (i) the level of unidentified problem loans given current economic and business conditions; (ii) the timing of the realization of impairment; (iii) the gross exposure of a credit facility at the time of default; and (iv) the ultimate severity of loss. In determining the appropriate level of general allowance, management first employs statistical models using historical loss rates and risk parameters to estimate a range of probable losses over an economic cycle. Management then considers changes in the credit granting process including underwriting, limit setting and the workout process in order to adjust historical experience to better reflect the current environment. In addition, current credit information including portfolio composition, credit quality trends and economic and business information is assessed to determine the appropriate allowance level.
     For heterogeneous loans (wholesale loans including small business loans managed individually), the general allowance is based on the application of estimated probability of default, gross exposure at default and loss factors, which are determined by historical loss experience and delineated by loan type and rating. These parameters are based on historical loss rates (default migration, loss severity and exposure at default), supplemented by industry studies and are updated on a regular basis. This approach allows us to generate a range of potential losses over an economic cycle. One of the key judgmental factors that influence the loss estimate for this portfolio is the application of the internal risk rating framework, which relies on our quantitative and qualitative assessments of a borrower’s financial condition in order to assign an internal credit risk rating similar to those used by external rating agencies. Any material change in the above parameters or assumptions would affect the range of probable credit losses and consequently may affect the general allowance level.
     For homogeneous portfolios (retail loans) including residential mortgages, credit cards, as well as personal and small business loans that are managed on a pooled basis, the determination of the general allowance is based on the application of historical loss rates. Historical loss rates are applied to current outstanding loans to determine a range of probable losses over an economic cycle.
     In determining the general allowance level, management also considers the current portfolio credit quality trends, business and economic conditions, the impact of policy and process changes, and other supporting factors. In addition, the general allowance includes a component for the model limitations and imprecision inherent in the allowance methodologies.
     Any fundamental change in methodology is subject to independent vetting and review.
Total allowance for credit losses
Based on the procedures discussed above, management believes that the total allowance for credit losses of $1,572 million is adequate to absorb estimated credit losses incurred in the lending portfolio as at October 31, 2007. This amount includes $79 million classified in other liabilities, which relates to letters of credit and guarantees and unfunded commitments. The year-over-year increase of $86 million largely reflects the increase in impaired loans.
Fair value of financial instruments
With the adoption of the three new accounting standards related to financial instruments on November 1, 2006, a greater portion of our Consolidated Balance Sheet is now measured at fair value. Refer to Note 1 to our Consolidated Financial Statements for a detailed discussion. Under the new standards, all financial instruments are required to be measured at fair value on initial recognition except for certain related party transactions. Measurement in subsequent periods depends on whether the financial instruments have been classified or designated as held-for-trading, available-for-sale, held-to-maturity, loans and receivables or other financial liabilities.
     Financial assets and financial liabilities held-for-trading, including derivative instruments, are measured at fair value with changes in the fair values recognized in net income, except for derivatives designated in effective cash flow hedges or hedges of foreign currency exposure of a net investment in a self-sustaining foreign operation; the changes in the fair values of those derivatives are recognized in Other comprehensive income (OCI). Available-for-sale financial assets are also measured at fair value with unrealized gains and losses, including changes in foreign exchange rates, being recognized in OCI except for investments in equity instruments classified as available-for-sale that do not have a quoted market price in an active market, which are measured at cost. Financial assets held-to-maturity, loans and receivables, and other financial liabilities are measured at amortized cost using the effective interest method.
     At October 31, 2007, approximately $276 billion, or 46%, of our financial assets and $205 billion, or 36%, of our financial liabilities were carried at fair value ($184 billion, or 34%, of financial assets and
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 39

 

 

$80 billion, or 16%, of financial liabilities at October 31, 2006). Note 2 to our Consolidated Financial Statements provides disclosure of the fair value of our financial instruments as at October 31, 2007.
     Fair value is defined as the amount at which a financial instrument could be bought or sold in a current transaction, other than in a forced or liquidation sale, between knowledgeable and willing parties in an arm’s-length transaction under no compulsion to act. The best evidence of fair value is quoted bid or ask price, as appropriate, in an active market. Where bid and ask prices are unavailable, we use the closing price of the most recent transaction of that instrument subject to the liquidity adjustments referred to below. Where quoted prices are not available for a particular financial instrument, we use the quoted price of a financial instrument with similar characteristics and risk profiles or internal or external valuation models using observable market-based inputs to estimate the fair value.
     The determination of fair value for actively traded financial instruments that have quoted market prices or readily observable model input parameters requires minimal subjectivity. Management’s judgment is required, however, when the observable market prices and parameters do not exist. In addition, management exercises judgment when establishing market valuation adjustments for liquidity when we believe that the amount realized on sale may be less than the estimated fair value due to insufficient liquidity over a short period of time. This includes adjustments calculated when market prices are not observable due to insufficient trading volume or a lack of recent trades in a less active or inactive market. In addition, liquidity adjustments are calculated to reflect the cost of unwinding a larger than normal market risk position.
     The majority of our financial instruments classified as held-for-trading other than derivatives and financial assets classified as available-for-sale comprise or relate to actively traded debt and equity securities, which are carried at fair value based on available quoted prices. As few derivatives and financial instruments designated as held-for-trading are actively quoted, we rely primarily on internally developed pricing models and established industry standard pricing models, such as Black-Schöles, to determine fair value. In determining the assumptions to be used in our pricing models, we look primarily to external readily observable market inputs including factors such as interest rate yield curves, currency rates and price and rate volatilities as applicable. However, certain derivative financial instruments are valued using significant unobservable market inputs such as default correlations, among others. These inputs are subject to significantly more quantitative analysis and management judgment. Where input parameters are not based on market observable data, we defer the initial trading profit until the amounts deferred become realized through the receipt and/or payment of cash or once the input parameters are observable in the market. We also record fair value adjustments to account for measurement uncertainty due to model risk and parameter uncertainty when valuing complex or less actively traded financial instruments. For further information on our derivative instruments, refer to Note 7 to our Consolidated Financial Statements.
     The following table summarizes our significant financial assets and liabilities carried at fair value, by valuation methodology at October 31, 2007 and October 31, 2006. We have applied the general concepts contained in the accounting standards related to financial instruments under Canadian GAAP to determine the classification of assets and liabilities carried at fair value among the valuation methodology groupings below.
     Instruments grouped within “quoted prices” include those where prices are obtained from an exchange, dealer, broker, industry group, pricing service or regulatory agency, or net asset values provided by fund managers of mutual funds and hedge funds. Instruments priced based on models are grouped based on whether the models include significant observable or unobservable parameters. Where fair value is not evidenced by observable market parameters, and day one unrealized gains and losses are not permitted under Canadian GAAP, the instrument is grouped as being based on “pricing models with significant unobservable market parameters.”
     In September 2006, the U.S. Financial Accounting Standards Board (FASB) issued FAS 157, Fair Value Measurements, which includes measurement guidance and requires that all financial instruments measured at fair value be categorized in fair value hierarchy levels. We have not adopted these measurement and disclosure requirements for U.S. GAAP reconciliation disclosure purposes, and the information contained in the table below is not intended to correspond to those levels.
     
Assets and liabilities carried at fair value by valuation methodology   Table 4
                                                                                 
    2007     2006 (1)  
            Based on             Based on  
                    Pricing     Pricing                             Pricing     Pricing        
                    models with     models with                             models with     models with        
                    significant     significant                             significant     significant        
                    observable     unobservable                             observable     unobservable        
(C$ millions,           Quoted     market     market                     Quoted     market     market        
except percentage amounts)   Fair value     prices     parameters     parameters     Total     Fair value     prices     parameters     parameters     Total  
Financial assets
                                                                                
Required to be classified as held-for-trading other than derivatives (2)
   $ 129,408       82 %     18 %     —       100 %   $ 147,237       87 %     13 %   $ —       100 %
Derivatives (3)
     65,568       —       100 %     —       100 %     37,008       —       100 %     —       100 %
Designated as held-for-trading (2)
     52,580       36 %     64 %     —       100 %     n.a.       n.a.       n.a.       n.a.       n.a.  
Classified as available-for-sale
     28,811       70 %     28 %     2 %     100 %     n.a.       n.a.       n.a.       n.a.       n.a.  
 
 
   $ 276,367                                     $ 184,245                                  
 
Financial liabilities
                                                                                
Required to be classified as held-for-trading other than derivatives (2)
   $ 46,328       89 %     11 %     —       100 %   $ 38,252       97 %     3 %   $ —       100 %
Derivatives (4)
     71,422       —       99 %     1 %     100 %     41,728       —       100 %     —       100 %
Designated as held-for-trading (2)
     87,433       —       100 %     —       100 %     n.a.       n.a.       n.a.       n.a.       n.a.  
 
 
   $ 205,183                                     $ 79,980                                  
 
(1)   Prior to the adoption of the new accounting standards related to financial instruments on November 1, 2006, there were no financial assets or financial liabilities designated as held-for-trading and there were no financial assets classified as available-for-sale. Consequently, prior period comparatives are not applicable (n.a.).
 
(2)   The categories of financial instruments are explained in Note 1 to our Consolidated Financial Statements.
 
(3)   The fair value excludes margin requirements of $1,017 million (2006 — $721 million).
 
(4)   The fair value excludes market and credit valuation adjustments of $588 million (2006 — $366 million).
Royal Bank of Canada: Annual Report 2007
40 Management’s Discussion and Analysis

 

 

2007 vs. 2006
With the adoption of the new financial instruments accounting standards, there are new categories of financial instruments carried at fair value such as financial assets and financial liabilities designated as held-for-trading and financial assets classified as available-for-sale which were carried at amortized cost prior to November 1, 2006. Further, all derivatives are now carried at fair value whereas prior to that date, only derivatives other than designated hedging instruments were carried at fair value. Accordingly, the comparative amounts for 2006 in the above table do not include these financial instruments.
     The decrease of $18 billion in financial assets classified as held-for-trading and the increase of $8 billion in financial liabilities classified as held-for-trading in 2007 are primarily due to our equity and bond securities held related to our proprietary equity arbitrage and fixed income trading businesses, where we offset the risks from our securities holdings by short selling other securities that are of similar risks to those in our portfolios. The increase of $29 billion in derivative assets and of $30 billion in derivative liabilities in 2007, primarily in foreign exchange and interest rate contracts, are largely due to increased volatility, strong shifts in exchange rates and interest rates, and higher client and trading activity, partially offset by the weakening of the U.S. dollar relative to the Canadian dollar. These activities are consistent with our strategy for these businesses and the increases in 2007 are within the approved risk limits.
     The determination of fair value where quoted prices are not available, and the identification of appropriate valuation adjustments require management judgment and are based on quantitative research and analysis. Our risk management group is responsible for establishing our valuation methodologies and policies, which address the use and calculation of valuation adjustments. These methodologies are reviewed on an ongoing basis to ensure that they remain appropriate. Risk management’s oversight in the valuation process also includes ensuring all significant financial valuation models are strictly controlled and regularly recalibrated and vetted to provide an independent perspective. During the year, there was no significant change to our methodologies for determining fair value, including those for establishing any valuation adjustments. Refer to the Risk management section for further detail on the sensitivity of financial instruments used in trading and non-trading activities.
Other-than-temporary impairment of available-for-sale and held-to-maturity securities
Available-for-sale and held-to-maturity securities are assessed for impairment at each reporting date. When the fair value of any security has declined below its amortized cost, management is required to assess whether the decline is other-than-temporary. In making this assessment, we consider such factors as the type of investment, the length of time and extent to which the fair value has been below the amortized cost, the financial and credit aspects of the issuer, and our intent and ability to hold the investment long enough to allow for any anticipated recovery. The decision to record a writedown, its amount and the period in which it is recorded could change if management’s assessment of one or more of those factors is different. If the decline in value is considered to be other-than-temporary, the cumulative changes in the fair values of available-for-sale securities previously recognized in Accumulated other comprehensive income (AOCI) are reclassified to net income during that period. For further details, refer to Notes 1 and 3 to our Consolidated Financial Statements.
Securitization
We periodically securitize Canadian residential mortgages, credit card receivables and commercial mortgage loans by selling them to special purpose entities (SPEs) or trusts that issue securities to investors. Some of the key accounting determinations in a securitization of our loans are whether the transfer of the loans meets the criteria required to be treated as a sale and, if so, the valuation of our retained interests in the securitized loans. Refer to Note 1 to our Consolidated Financial Statements for a detailed description of the accounting policy for loan securitization.
     When we securitize loans and retain an interest in the securitized loans, it is a matter of judgment whether the loans have been legally isolated. We obtain legal opinions where required to give us comfort that legal isolation of the transferred loans has been achieved. We often retain interests in securitized loans such as interest-only strips, servicing rights or cash reserve accounts. Where quoted market prices are not available, the valuation of retained interests in sold assets is based on our best estimate of several key assumptions such as the payment rate of the transferred loans, weighted average life of the prepayable receivables, excess spread, expected credit losses and discount rate. The fair value of such retained interests calculated using these assumptions affects the gain or loss that is recognized from the sale of the loans. Refer to Note 5 to our Consolidated Financial Statements for the volume of securitization activities of our loans, the gain or loss recognized on sale and a sensitivity analysis of the key assumptions used in valuing our retained interests.
     Another key accounting determination is whether the SPE that is used to securitize and sell our loans is required to be consolidated. As described in Note 6 to our Consolidated Financial Statements, we concluded that none of the SPEs used to securitize our financial assets should be consolidated.
Variable interest entities
Canadian Institute of Chartered Accountants (CICA) Accounting Guideline 15, Consolidation of Variable Interest Entities (AcG-15), provides guidance on applying the principles of consolidation to certain entities defined as variable interest entities (VIEs). Where an entity is considered a VIE, the Primary Beneficiary is required to consolidate the assets, liabilities and results of operations of the VIE. The Primary Beneficiary is the entity that is exposed, through variable interests, to a majority of the VIE’s expected losses (as defined in AcG-15) or is entitled to a majority of the VIE’s expected residual returns (as defined in AcG-15), or both.
     We use a variety of complex estimation processes involving both qualitative and quantitative factors to determine whether an entity is a VIE, and, if required, to analyze and calculate the expected losses and the expected residual returns. These processes involve estimating the future cash flows and performance of the VIE, analyzing the variability in those cash flows, and allocating the losses and returns among the identified parties holding variable interests to determine who is the Primary Beneficiary. In addition, there is a significant amount of judgment exercised in interpreting the provisions of AcG-15 and applying them to our specific transactions.
     AcG-15 applies to a variety of our businesses, including our involvement with multi-seller conduits we administer, credit investment products and structured finance transactions. For further details on our involvement with VIEs, refer to the Off-balance sheet arrangements section and Note 6 to our Consolidated Financial Statements.
Pensions and other post-employment benefits
We sponsor a number of defined benefit and defined contribution plans providing pension and other benefits to eligible employees after retirement. These plans include registered pension plans, supplemental pension plans and health, dental, disability and life insurance plans. The pension plans provide benefits based on years of service, contributions and average earnings at retirement.
     Due to the long-term nature of these plans, the calculation of benefit expenses and obligations depends on various assumptions such as discount rates, expected rates of return on assets, health care cost trend rates, projected salary increases, retirement age, mortality and termination rates. The discount rate assumption is determined using a yield curve of AA corporate debt securities. All other assumptions are determined by management and are reviewed annually by the actuaries. Actual experience that differs from the actuarial assumptions will affect the amounts of benefit obligation and expense. The weighted average assumptions used and the sensitivity of key assumptions are presented in Note 20 to our Consolidated Financial Statements.
Income taxes
Management exercises judgment in estimating the provision for income taxes. We are subject to income tax laws in various jurisdictions where we operate. These complex tax laws are potentially subject to different interpretations by the taxpayer and the relevant tax authority. The provision for income taxes represents management’s interpretation of the relevant tax laws and its estimate of current and future income tax implications of the transactions and events during the period. A future income tax asset or liability is determined for each temporary difference based on the future tax rates that are expected to be in effect and management’s assumptions regarding the expected timing of the reversal of such temporary differences.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 41

 

 

Future Changes in Accounting Policies
Future changes in accounting policies and disclosure
Canadian GAAP
Capital Disclosures and Financial Instruments — Disclosures and Presentation
On December 1, 2006, CICA issued three new accounting standards:
Handbook Section 1535, Capital Disclosures (Section 1535), Handbook Section 3862, Financial Instruments — Disclosures (Section 3862), and Handbook Section 3863, Financial Instruments — Presentation (Section 3863). These new standards became effective for us on November 1, 2007.
     Section 1535 requires the disclosure of (i) an entity’s objectives, policies and processes for managing capital; (ii) quantitative data about what the entity regards as capital; (iii) whether the entity has complied with any capital requirements; and (iv) if it has not complied, the consequences of such non-compliance.
     Sections 3862 and 3863 replace Handbook Section 3861, Financial Instruments — Disclosure and Presentation, revising and enhancing its disclosure requirements, and carrying its presentation requirements forward unchanged. These new sections place increased emphasis on disclosures about the nature and extent of risks arising from financial instruments and how the entity manages those risks.
U.S. GAAP
Guidance on accounting for income taxes
FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109 (FIN 48), on July 13, 2006, and its related Staff Position FIN 48-1, Definition of Settlement in FASB Interpretation No. 48 (FSP FIN 48-1), on May 2, 2007. FIN 48 and FSP FIN 48-1 provide additional guidance on how to recognize, measure and disclose income tax benefits. FIN 48 became effective for us on November 1, 2007, and we do not expect it will have a material impact on our consolidated financial position and results of operations.
Framework on fair value measurement
On September 15, 2006, FASB issued FASB Statement No. 157, Fair Value Measurements (FAS 157), which establishes a framework for measuring fair value in U.S. GAAP and is applicable to other accounting pronouncements where fair value is considered to be the relevant measurement attribute. FAS 157 also expands disclosures about fair value measurements and will be effective for us on November 1, 2008. We are currently assessing the impact of adopting this standard on our consolidated financial position and results of operations.
Fair value option for financial assets and liabilities
On February 15, 2007, FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Liabilities (FAS 159). FAS 159 provides an entity the option to report selected financial assets and liabilities at fair value and establishes new disclosure requirements for assets and liabilities to which the fair value option is applied. FAS 159 will be effective for us on November 1, 2008. We are currently assessing the impact of adopting this standard on our consolidated financial position and results of operations.
Controls and procedures
Disclosure controls and procedures
Our disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by us is recorded, processed, summarized and reported within the time periods specified under Canadian and U.S. securities laws and include controls and procedures that are designed to ensure that information is accumulated and communicated to management, including the President and Chief Executive Officer, and Chief Financial Officer, to allow timely decisions regarding required disclosure.
     Management evaluated, under the supervision of and with the participation of the President and CEO, and Chief Financial Officer, the effectiveness of our disclosure controls and procedures as defined under Multilateral Instrument 52-109 and the U.S. Securities Exchange Act of 1934 as of October 31, 2007. Based on that evaluation, the President and Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of October 31, 2007.
Internal control over financial reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Management assessed the effectiveness of our internal control over financial reporting as of October 31, 2007, and based on that assessment, concluded that our internal control over financial reporting was effective. See page 112 for Management’s report on internal control over financial reporting and the Report of Independent Registered Chartered Accountants. No changes were made in our internal control over financial reporting during the year ended October 31, 2007, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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42 Management’s Discussion and Analysis

 

 

FINANCIAL PERFORMANCE
Overview
2007 vs. 2006
We reported record net income of $5,492 million for the year ended October 31, 2007, up $764 million, or 16%, from a year ago. Diluted EPS were $4.19, up 17% compared to a year ago. ROE was 24.6%, compared to 23.5% a year ago. Our strong results were largely attributable to profitable volume and balance growth in our banking and wealth management businesses, strong Global Insurance results, and increased equity and foreign exchange trading results and strong equity origination activity in our capital markets businesses. These results reflected the ongoing successful execution of our growth initiatives as well as generally favourable economic and market conditions for most of the year. For additional discussion on the performance of our business segments, refer to the Business Segment results section starting on page 57. A gain related to the Visa Inc. restructuring and the exchange of our membership interest in Visa Canada Association for shares of Visa Inc. also contributed to the increase. These factors were partially offset by the writedowns on the valuation of U.S. subprime residential mortgage-backed securities (RMBS) and collateralized debt obligations of asset-backed securities (CDOs of ABS) reflecting the deterioration in credit markets since July 2007, higher provisions for credit losses reflecting portfolio growth and higher impaired loans in our U.S. residential builder finance business, and higher credit card customer loyalty reward program costs. Also partly offsetting the favourable factors were higher costs in support of our business growth and the negative impact of a stronger Canadian dollar on the translated value of our U.S. dollar-denominated earnings. The Tier 1 capital ratio of 9.4% was down 20 bps from 9.6% a year ago, while the Total capital ratio of 11.5% was down 40 bps from 11.9% a year ago.
U.S. subprime
In October 2007, the credit markets deteriorated dramatically after rating agencies downgraded a broad group of U.S. subprime RMBS and CDOs of ABS. Following these events, we recognized a charge of $357 million before-tax in Capital Markets, consisting of writedowns on the fair value of our direct holdings of U.S. subprime RMBS and CDOs of ABS and related credit default swaps.
     Our Capital Markets holdings of RMBS and CDOs of ABS arose primarily in relation to our role in structuring CDOs of ABS and are classified as held-for-trading, with unrealized changes in fair value reflected in our Non-interest income. Our other holdings are RMBS and are classified as available-for-sale, and unrealized changes in fair value are generally reflected in Other comprehensive income. These changes are reflected in Non-interest income only if management determines that it is appropriate that the value be written down (referred to as “other-than-temporary impairment”).
     As at October 1, 2007, Capital Markets had $216 million of net exposure to U.S. subprime CDOs of ABS, after taking into consideration protection provided by credit default swaps. We have credit default swaps providing protection of $240 million, recorded at fair market value of $104 million, with counterparties rated less than AAA by Standard & Poor’s (S&P) and less than Aaa by Moody’s Investors Service (Moody’s). Other credit default swaps provide an additional $1,053 million or protection against our gross exposure and are either collateralized or with counterparties rated AAA by S&P and Aaa by Moody’s.
     As at October 31, 2007, we had $388 million of exposure to U.S. subprime RMBS recorded as available-for-sale, which we intend to hold until maturity. As at October 31, 2007, Capital Markets had no net exposure to U.S. subprime RMBS after taking into account credit default swaps that provide $1,113 million of protection and are either collateralized or with counterparties rated AAA by S&P and Aaa by Moody’s.
Canadian non-bank-sponsored asset-backed commercial paper
As at October 31, 2007, we had $4 million of direct holdings of Canadian non-bank-sponsored asset-backed commercial paper conduits where liquidity is contingent on a general market disruption. We are not a significant participant in this market as a distributor or a liquidity provider.
Structured investment vehicles
We had $1 million of direct holdings, $140 million of committed liquidity facilities and $88 million of normal course interest rate derivatives with structured investment vehicles (SIVs) as at October 31, 2007. Our liquidity facilities remained undrawn at October 31, 2007 and we do not consider any of our positions to be impaired. We do not manage any SIVs.
Impact of U.S. vs. Canadian dollar
The translated value of our consolidated results is impacted by fluctuations in the respective exchange rates relative to the Canadian dollar. The following table depicts the effect of translating current year Canadian dollar/U.S. dollar consolidated results at the current exchange rate in comparison to the historical period’s exchange rate. We believe this provides the reader with the ability to assess the underlying results on a more comparable basis, particularly given the magnitude of the recent changes in the exchange rate and the resulting impact on our results.
     Certain of our business segment results are also impacted by fluctuations in the U.S. dollar, Euro and British pound exchange rates. For further details, refer to the Impact of foreign exchange rates on our business segments section.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 43

 

 

Impact of U.S. dollar vs. Canadian dollar   Table 5
                 
    2007 vs.     2006 vs.  
(C$ millions, except per share amounts)   2006     2005  
 
Canadian/U.S. dollar exchange rate (average)
                
2007
   $ 1.093     $    
2006
     1.132       1.132  
2005
             1.214  
Percentage change in average US$ equivalent of C$1.00 (1)
     4 %     7 %
 
Reduced total revenue
   $ 230     $ 425  
Reduced non-interest expense
     139       215  
Reduced net income
     47       123  
 
Reduced basic EPS
   $ .04     $ .10  
Reduced diluted EPS
   $ .04     $ .09  
 
(1)   Average amounts are calculated using month-end spot rates for the period.
In 2007, the Canadian dollar appreciated 4% on average compared to a year ago resulting in a $47 million decrease in the translated value of our U.S. dollar-denominated net income and a decrease of $.04 in our current year’s diluted EPS.
Impact of the new financial instruments accounting standards
On November 1, 2006, we adopted three new accounting standards related to financial instruments that were issued by CICA. The standards require a greater portion of our Consolidated Balance Sheet to be measured at fair value with changes in the fair values reported in income in the period they occur, except for available-for-sale securities, derivatives designated as cash flow hedges, and hedges of net investments in foreign operations, the changes in fair value of which are recognized in OCI. The standards also provide new guidance on the accounting for derivatives in hedging relationships.
     The following table provides the main impacts on our Consolidated Statements of Income arising from the application of the new financial instruments accounting standards. For further details about the financial instruments accounting standards, refer to Notes 1 and 2 to our Consolidated Financial Statements.
     
Impact of the new financial instruments accounting standards   Table 6
                 
(C$ millions)   2007     Significantly impacted segments  
 
Net interest income
   $ 22     Canadian Banking
Non-interest income
                
Insurance premiums, investment and fee income
     (160 )   Canadian Banking
Trading revenue
     18     Capital Markets
Other
     35     Wealth Management
Other
     8     Corporate Support
 
Total revenue
   $ (77 )        
Insurance policyholder benefits, claims and acquisition expense
     (154 )   Canadian Banking
Net income
     55          
 
Canadian Banking
For the year ended October 31, 2007, we recognized a $22 million increase in net interest income related to the application of the effective interest method on our residential mortgage portfolio. In addition, we recorded a loss of $160 million in Insurance premiums, investment and fee income related to the changes in the fair values of the securities backing our life and health insurance businesses. These losses were largely offset by a corresponding $154 million decrease in the measurement of certain liabilities related to life and health insurance policies, recorded in Insurance policyholder benefits, claims and acquisition expense.
Capital Markets
For the year ended October 31, 2007, we recognized a gain of $18 million in Trading revenue as a result of the net increase in fair values in various trading portfolios previously measured at amortized cost. This gain includes a $59 million gain on our deposit liabilities designated as held-for-trading resulting from the widening of our own credit spread during the year.
Wealth Management
For the year ended October 31, 2007, we recorded a $35 million foreign currency translation gain in Non-interest income — Other related to deposits used to fund certain Available-for-sale securities denominated in foreign currencies in order to minimize exposure to changes in foreign exchange rates. The corresponding foreign currency translation loss on the related Available-for-sale securities was recorded in AOCI.
Corporate Support
For the year ended October 31, 2007, we recognized a gain of $8 million. This consisted of a $32 million gain in Non-interest income — Other related to certain long-term funding notes and subordinated debentures that were issued and designated as held-for-trading liabilities, including a $29 million gain related to the widening of our own credit spread during the year. These amounts were largely offset by $24 million of mark-to-market losses mainly related to the recognition of the ineffectiveness of hedged items and the related derivatives in hedge accounting relationships.
Summary of 2006 and 2005
In 2006, we achieved net income of $4,728 million, up $1,341 million, or 40%, from 2005. Our strong earnings reflected solid business growth across all business segments and our successful execution of growth initiatives, despite the negative impact of the strong Canadian dollar on the translated value of our foreign currency-denominated results. Our 2005 results reflected the Enron litigation-related provision. Our strong results in 2006 were also underpinned by generally favourable economic and credit conditions in both domestic and international markets.
     In 2006, the Canadian economy grew by 2.8%, primarily bolstered by robust domestic demand. These factors were partially offset by a weakening in exports and manufacturing activities against a backdrop of a strong Canadian dollar, high but falling energy prices, slowing U.S. demand and competition from emerging markets. The U.S. economy recorded a growth rate of 2.9%, reflecting solid consumer and business spending supported by strong balance sheets as well as strength in the labour market, though partly restrained by the lagged effects of increases in interest rates and high but falling energy prices.
Royal Bank of Canada: Annual Report 2007
44  Management’s Discussion and Analysis

 

 

     During 2006, strong consumer lending was supported by favourable labour market conditions and a relatively low interest rate environment. Business lending remained solid, albeit in part offset by surpluses of internally generated funds available for capital and inventory investment. The favourable credit environment, together with healthy household and corporate balance sheets, continued to support strong consumer and business credit quality. Capital market conditions were generally favourable, characterized by buoyant M&A activity in Canada and strong performance of natural resource-based equities. Debt origination activity in the U.S. and Europe weakened in 2006 in part due to rising interest rates and the negative impact of the strengthening of the Canadian dollar.
     During 2006, a number of specified items were identified, which had minimal impacts on our overall results as their effects largely offset each other. We realized a favourable resolution of an income tax audit related to prior years, resulting in a $70 million reduction in income tax expense. We received $51 million related to the termination of an agreement. We reversed $50 million of general allowance related to our corporate loan portfolio. We also recorded a net gain of $40 million on the exchange of New York Stock Exchange (NYSE) seats for shares in the NYSE Group (NYX). We incurred a net charge of $16 million ($19 million after-tax, which included a write-off of deferred taxes) related to the transfer of our Institutional & Investor Services business to the joint venture RBC Dexia IS. We recorded a $61 million (before-tax and after-tax) charge in our insurance business for additional estimated net claims for damages predominantly related to hurricane Wilma, which occurred in late 2005. In addition, we made a $72 million adjustment to increase our credit card customer loyalty reward program costs.
     In 2005, net income was $3,387 million, up $584 million, or 21%, from 2004. Our strong earnings were supported by our successful execution of client-focused initiatives and favourable economic conditions, despite the negative impact of an Enron Corp. litigation-related provision and charges for net claims related to hurricanes Katrina, Rita and Wilma.
     In 2005, the Canadian economy grew by 3.1% (1), reflecting strong consumer and business spending underpinned by low interest rates, robust employment growth and rising house prices, albeit partially offset by the adverse effects of a strong Canadian dollar and higher energy prices. The U.S. economy recorded a growth rate of 3.1% (1), fuelled by strong consumer spending amid solid job growth and surging house prices, despite increases in interest rates and energy prices and the dampening impacts of hurricanes Katrina, Rita and Wilma. Business investment in the U.S. was buoyed by both capital and inventory investment. Strong consumer credit quality was supported by resilient debt-servicing capacity and high household liquidity, while business credit quality continued to reflect a favourable credit and business environment with a general reduction in defaults and bankruptcies.
     During 2005, we took action to mitigate the uncertainties regarding Enron-related matters, including the settlement of our part of the MegaClaims bankruptcy lawsuit brought by Enron against RBC and a number of financial institutions for $31 million (US$25 million). In addition, we settled an additional $29 million (US$24 million) for recognition of claims against the Enron bankruptcy. We also established a provision of $591 million (US$500 million) or $326 million aftertax (US$276 million after-tax) for Enron litigation-related matters. We recorded a charge of $203 million (US$173 million) before- and after-tax for estimated net claims for damages related to hurricanes Katrina, Rita and Wilma. We completed the sale of Liberty Insurance Services Corporation (LIS) to IBM Corporation (IBM), and entered into a long-term agreement with IBM to perform key business processes for RBC Insurance U.S. operations. We also completed the sale of certain assets of RBC Mortgage Company (RBC Mortgage) to Home123 Corporation.
(1)   Reflects revised data from Statistics Canada and the Bureau of Economic Analysis.
     
Total revenue   Table 7
                         
(C$ millions)   2007     2006     2005  
 
Interest income
   $ 26,377     $ 22,204     $ 16,981  
Interest expense
     18,845       15,408       10,188  
 
Net interest income
   $ 7,532     $ 6,796     $ 6,793  
 
Investments (1)
   $ 4,405     $ 3,786     $ 3,357  
Insurance (2)
     3,152       3,348       3,270  
Trading
     2,261       2 ,574       1,594  
Banking (3)
     2,620       2,391       2,326  
Underwriting and other advisory
     1,217       1,024       1,026  
Other (4)
     1,275       718       818  
 
Non-interest income
   $ 14,930     $ 13,841     $ 12,391  
 
Total revenue
   $ 22,462     $ 20,637     $ 19,184  
 
Additional information
                        
Total trading revenue (5)
                        
Net interest income — related to trading activities
   $ (390 )   $ (539 )   $ 21  
Non-interest income — trading revenue
     2,261       2,574       1,594  
 
Total
   $ 1,871     $ 2,035     $ 1,615  
 
Total trading revenue by product (5)
                        
Interest rate and credit
   $ 693     $ 1,174     $ 1,025  
Equities
     823       561       355  
Foreign exchange and commodities
     355       300       235  
 
Total
   $ 1,871     $ 2,035     $ 1,615  
 
(1)   Includes brokerage, investment management and mutual funds.
 
(2)   Includes premiums, investment and fee income.
 
(3)   Includes service charges, foreign exchange other than trading, card services and credit fees.
 
(4)   Includes other non-interest income, gain/loss on securities sales and securitization.
 
(5)   Total trading revenue comprises trading-related revenue recorded in Net interest income and Non-interest income. Total trading revenue includes cash and related derivatives.
     
  Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  45

 

 

2007 vs. 2006
Total revenue increased $1,825 million, or 9%, from a year ago. Excluding the impact of the new financial instruments accounting standards, revenue was up $1,902 million, or 9%. The increase was largely due to continued strong balance and volume growth in our banking and wealth management businesses and a gain related to the Visa Inc. restructuring. Higher revenue from several capital markets businesses also contributed to this increase. The strong growth largely reflected the successful execution of our strategy including acquisitions, as well as generally favourable market conditions for most of the year. These factors were partially offset by writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS, the negative impact of a stronger Canadian dollar on the translated value of our U.S. dollar-denominated revenue and higher credit card customer loyalty reward program costs. For a reconciliation of revenue excluding the impact of the new financial instruments accounting standards, refer to the Key performance and non-GAAP measures section.
     Net interest income increased $736 million, or 11%, largely driven by strong loan and deposit growth. Net interest margin of 1.30% was down 5 bps compared to the prior year.
     Investments-related revenue increased $619 million, or 16%, primarily due to continued growth in fee-based client assets reflecting strong net sales, capital appreciation and the recruitment and retention of experienced advisors. Growth in custodian and securities lending businesses reflecting strong market activities, and higher transactional volumes in our brokerage businesses also contributed to the increase.
     Insurance-related revenue decreased $196 million, or 6%. Excluding the impact of the new financial instruments accounting standards, revenue decreased $36 million, or 1%, from the prior year, largely reflecting lower U.S. annuity sales mainly due to relatively lower long-term interest rates and lower revenue from our property catastrophe reinsurance business, which we exited completely this year. These factors were partially offset by growth in our European life reinsurance and Canadian businesses. For a reconciliation of Insurance-related revenue excluding the impact of the new financial instruments accounting standards, refer to the Key performance and non-GAAP measures section.
     Banking revenue was up $229 million, or 10%, mainly due to higher transaction volumes and client balances and increased loan syndication activity. These factors were partially offset by higher credit card customer loyalty reward program costs that were recorded against revenue.
     Trading revenue decreased by $313 million, or 12%. Total trading revenue was $1,871 million, down $164 million, or 8%, from a year ago largely due to writedowns totalling $357 million on the valuation of U.S. subprime RMBS and CDOs of ABS in our Structured Credit business.
     Underwriting and other advisory revenue increased $193 million, or 19%, on strong equity origination activity across all geographies and improved M&A results, mainly in the U.S. These factors were partially offset by lower U.S. debt origination activity in part due to the tightening of credit markets in the latter part of 2007 as a result of the U.S. subprime mortgage market concerns.
     Other revenue increased $557 million, or 78%, largely due to a $326 million gain related to the Visa Inc. restructuring and gains on the fair valuing of credit derivatives used to economically hedge our corporate loan portfolio. A favourable adjustment of $40 million related to the reallocation of certain foreign investment capital from our international insurance operations, which had supported our property catastrophe reinsurance business, as we exited this business completely this year, a $35 million foreign exchange translation gain on certain deposits resulting from the implementation of the new financial instruments accounting standards, and higher private equity gains and distributions also contributed to the increase.
2006 vs. 2005
Total revenue increased $1,453 million, or 8%, from 2005, largely due to record trading results on improved market conditions and solid business growth in our wealth management and banking businesses reflecting successful execution of our growth initiatives and favourable market conditions. Strong M&A activity and the net gain on the exchange of our NYSE seats for NYX shares, also contributed to the increase. These factors were partially offset by a reduction of $425 million due to the negative impact of the stronger Canadian dollar on the translated value of our U.S. dollar-denominated revenue, lower debt and equity origination activity and certain favourable items recorded in 2005.
     Net interest income increased $3 million. Strong loan and deposit growth and increased spreads on deposits and personal investment products were mostly offset by funding costs related to certain equity trading strategies and the impact of higher securitization balances.
     Investments-related revenue increased $429 million, or 13%, primarily due to growth in fee-based client assets reflecting strong net sales and capital appreciation and the inclusion of Abacus Financial Services Group Limited. Higher transactional volumes in our full service and self-directed brokerage businesses also contributed to the increases.
     Insurance-related revenue increased $78 million, or 2%, primarily reflecting growth in our Canadian life business and European life reinsurance business. This was partially offset by lower revenue in our U.S. life business largely due to lower annuity sales, the negative impact of a stronger Canadian dollar on the translated value of our U.S. dollar-denominated revenue and lower revenue from property catastrophe reinsurance reflecting our strategic reduction in exposure, as we ceased underwriting new business.
     Banking revenue was up $65 million, or 3%, mainly due to higher service fees, higher credit fees related to our investment banking activity and increased foreign exchange revenue due to higher transaction volume. These factors were partially offset by higher customer loyalty reward program costs that were recorded against revenue.
     Trading revenue increased by $980 million, or 61%. Total trading revenue was $2,035 million, up $420 million, or 26%, from a year ago largely due to record trading results on improved market conditions and growth in certain equity trading strategies. This was partly offset by higher funding costs in support of growth in certain equity trading strategies.
     Underwriting and other advisory revenue decreased $2 million on lower equity origination in Canada mainly reflecting slower activity outside the resource sector and lower debt origination largely in the U.S. due to the rising interest rate environment. These factors were largely offset by stronger M&A activity.
     Other revenue decreased $100 million, or 12%, largely due to a number of favourable items recorded in 2005 including the gain on the sale of an Enron-related claim, a cumulative accounting adjustment related to our ownership interest in an investment and the gain on the sale of LIS. These factors were partially offset by the receipt of a fee related to the termination of an agreement and the net gain on the exchange of our NYSE seats for NYX shares, which were both recorded in 2006.
     
Net interest income and margin   Table 8
                         
(C$ millions, except percentage amounts)   2007     2006     2005  
 
   Net interest income
   $ 7,532     $ 6,796     $ 6,793  
   Average assets (1)
     581,000       502,100       445,300  
 
   Net interest margin (2)
     1.30 %     1.35 %     1.53 %
 
(1)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(2)   Net interest income as a percentage of average assets.
Royal Bank of Canada: Annual Report 2007
46  Management’s Discussion and Analysis

 

 

     
Change in net interest income (1)   Table 9
                                                 
    2007 vs. 2006             2006 vs. 2005        
    Increase (decrease)             Increase (decrease)        
    due to changes in             due to changes in        
    Average     Average     Net     Average     Average     Net  
(C$ millions)   volume(2)     rate(2)     change     volume (2)     rate (2)     change  
 
Assets
                                                
Deposits with other banks
                                                
Canada
   $ 11     $ (9 )   $ 2     $ 10     $ —     $ 10  
United States
     71       (50 )     21       11       89       100  
Other International
     31       4       35       35       104       139  
Securities
                                                
Trading
     1,142       423       1,565       863       482       1,345  
Available-for-sale (3)
     (230 )     141       (89 )     —       —       —  
Investments (3)
     —       —       —       22       216       238  
Asset purchased under reverse repurchase
agreements and securities borrowed
     783       (160 )     623       404       1,069       1,473  
Loans
                                                
Canada
                                               
Retail
     1,025       194       1,219       697       423       1,120  
Wholesale
     —       (217 )     (217 )     146       (144 )     2  
United States
     348       (218 )     130       108       376       484  
Other International
     778       106       884       172       140       312  
 
Total interest income
   $ 3,959     $ 214     $ 4,173     $ 2,468     $ 2,755     $ 5,223  
 
Liabilities
                                                
Deposits
                                                
Canada
   $ (1 )   $ 646     $ 645     $ 122     $ 1,178     $ 1,300  
United States
     264       281       545       238       733       971  
Other International
     1,344       528       1,872       754       737       1,491  
Obligations related to securities sold short
     386       (460 )     (74 )     197       493       690  
Obligations related to assets sold under
repurchase agreements and securities loaned
     542       (60 )     482       341       421       762  
Subordinated debentures
     (66 )     (15 )     (81 )     (18 )     (5 )     (23 )
Other interest-bearing liabilities
     89       (41 )     48       (115 )     144       29  
 
Total interest expense
   $ 2,558     $ 879     $ 3,437     $ 1,519     $ 3,701     $ 5,220  
 
Net interest income
   $ 1,401     $ (665 )   $ 736     $ 949     $ (946 )   $ 3  
 
(1)   Geographic classification for selected assets and liabilities is based on the domicile of the booking point of the subject assets and liabilities.
 
(2)   Volume/rate variance is allocated on the percentage relationship of changes in balances and changes in rates to the total net change in net interest income.
 
(3)   Available-for-sale securities are carried at fair value. Prior to November 1, 2006, Available-for-sale securities were classified as investment securities and were carried at amortized cost.
2007 vs. 2006
Net interest margin decreased 5 bps reflecting the impact of changes in product mix, an increase in lower-yielding and non-interest-earning assets, competitive pressures on our U.S. deposit business, and the reversal of accrued interest on higher impaired loans in the U.S.
     Net interest income increased $736 million, or 11%, largely driven by strong loan and deposit growth in our banking businesses.
     As noted in Table 9, we experienced higher growth in lower-yielding and non-interest-earning assets, including trading securities and assets purchased under reverse repurchase agreements and securities borrowed largely in support of our trading and other business activities, which generate non-interest income. For further details, refer to Table 58 in the Additional financial information section.
2006 vs. 2005
Net interest margin decreased 18 bps compared to 2005, reflecting lower net interest income due to higher funding costs in support of growth in certain equity trading strategies. An increase in lower-yielding and non-interest-earning assets, which generate non-interest income, largely in support of our trading and other business activities also contributed to the decrease. This decrease was partially offset by stronger loan and deposit growth and increased spreads on deposits and personal investment products.
     
Non-interest expense   Table 10
                         
(C$ millions)   2007     2006     2005  
 
Salaries
   $ 3,541     $ 3,192     $ 3,101  
Variable compensation
     2,975       2,827       2,309  
Stock-based compensation
     194       169       169  
Benefits and retention compensation
     1,150       1,080       1,103  
 
Human resources
   $ 7,860     $ 7,268     $ 6,682  
Equipment
     1,009       957       960  
Occupancy
     839       792       749  
Communications
     723       687       632  
Professional and other external services
     838       844       796  
Other expenses
     1,204       947       1,538  
 
Non-interest expense
   $ 12,473     $ 11,495     $ 11,357  
 
     
  Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  47

 

 

2007 vs. 2006
Non-interest expense increased $978 million, or 9%, compared to the prior year, primarily reflecting higher costs due to increased business levels, which included additional sales and service personnel and higher variable compensation on higher commission-based revenue in Wealth Management. Increased sundry losses and higher processing and system development costs also contributed to the increase. Additional costs in support of our growth initiatives, including our recent acquisitions, and de novo branch expansion and branch upgrade programs also contributed to the increase. These factors were partially offset by the favourable impact of a stronger Canadian dollar on the translated value of the U.S. dollar-denominated expenses and lower variable compensation in Capital Markets commensurate with weaker results.
2006 vs. 2005
Non-interest expense increased $138 million, or 1%, compared to 2005, largely reflecting higher variable compensation primarily in our Capital Markets and Wealth Management segments due to strong business performance. Higher costs in support of our growth initiatives, including a higher level of sales personnel and infrastructure in our distribution network, increased costs related to systems application development, higher marketing and advertising costs and a larger number of branches also contributed to the increase. These factors were partially offset by the reduction in the translated value of U.S. dollar-denominated expenses due to the stronger Canadian dollar. The Enron litigation-related provision and the settlement of the Enron MegaClaims bankruptcy lawsuit were recorded in 2005.
     
Provision for credit losses   Table 11
                         
(C$ millions)   2007     2006     2005  
 
Residential mortgages
   $ 13     $ 6     $ 2  
Personal
     364       306       259  
Credit cards
     223       163       194  
Small business (1)
     34       29       27  
 
Retail
   $ 634     $ 504     $ 482  
 
Business (2)
     148       (22 )     (93 )
Sovereign (3)
     —       —       —  
Bank
     —       —       —  
 
Wholesale
     148       (22 )     (93 )
 
Specific provision
   $ 782     $ 482     $ 389  
General provision
     9       (53 )     66  
 
Provision for credit losses
   $ 791     $ 429     $ 455  
 
Specific PCL as a % of average net loans and acceptances
     .33 %     .23 %     .21 %
 
(1)   Includes small business exposure managed on a pooled basis.
 
(2)   Includes small business exposure managed on an individual client basis.
 
(3)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
2007 vs. 2006
Total provision for credit losses (PCL) increased $362 million, or 84%, compared to the prior year, which had been at a cyclically low level, and has trended up towards the historical average. The increase reflected higher provisions for both of our wholesale and retail loan portfolios, primarily reflecting portfolio growth and higher impaired loans in our U.S. residential builder finance business triggered by the downturn in the U.S. housing market. Specific PCL as a percentage of average net loans and acceptances increased from a year ago, largely reflecting higher impaired loans in our U.S. residential builder finance business.
     Specific PCL for retail loans was up $130 million, or 26%, from a year ago. The increase was primarily attributable to higher provisions in our credit cards and personal unsecured credit line portfolios, largely reflecting higher loss rates and portfolio growth.
     Specific PCL for wholesale loans increased $170 million over the prior year. The increase was largely attributable to our business portfolio mainly due to higher impaired loans in our U.S. residential builder finance business and higher write-offs in Canada. Lower recoveries in our corporate loan portfolio this year also contributed to the increase in provisions.
     The general provision increased $62 million from a year ago, primarily reflecting a $50 million reversal of the general allowance related to our corporate loan portfolio in the prior year. Higher provisions in our U.S. residential builder finance business loan portfolio, largely reflecting a weakening in credit quality as a result of the downturn in the U.S. housing market, also contributed to the increase.
2006 vs. 2005
Provision for credit losses decreased $26 million, or 6%, from 2005. The decrease largely reflected a $50 million reversal of the general allowance in 2006 related to our corporate loan portfolio in Capital Markets, in light of the continued favourable credit conditions and the strengthening of the credit quality of our corporate portfolio, the favourable impact of the higher level of securitized credit cards, and the continued strong credit quality of our U.S. loan portfolio. In 2005, we also recorded a provision related to our 50% proportionate share of a provision booked at Moneris Solutions, Inc. (Moneris). These factors were partially offset by higher provisions for our Canadian personal loan and small business portfolios, as well as lower recoveries in our corporate and agriculture loan portfolios.
     
Insurance policyholder benefits, claims and acquisition expense   Table 12
                         
(C$ millions)   2007     2006     2005  
 
Insurance policyholder benefits and claims
   $ 1,588     $ 1,939     $ 2,103  
Insurance policyholder acquisition expense
     585       570       522  
 
Insurance policyholder benefits, claims and acquisition expense
   $ 2,173     $ 2,509     $ 2,625  
 
Royal Bank of Canada: Annual Report 2007
48 Management’s Discussion and Analysis

 

 

2007 vs. 2006
Insurance policyholder benefits, claims and acquisition expense (PBCAE) decreased $336 million, or 13%, from the prior year. Excluding the impact of the new financial instruments accounting standards and the prior year hurricane-related charges, PBCAE decreased $121 million, or 5%, over last year. The decrease was largely attributable to the impact of lower U.S. annuity sales and a higher level of favourable net actuarial liability adjustments this year, which included cumulative adjustments of $92 million related to prior periods. These factors were partially offset by increased costs commensurate with growth in our European life reinsurance and Canadian businesses. For a reconciliation of PBCAE excluding the impact of the new financial instruments accounting standards, refer to the Key performance and non-GAAP measures section.
2006 vs. 2005
PBCAE decreased $116 million, or 4%, compared to 2005. The decrease primarily reflected a $142 million (before- and after-tax) reduction in hurricane-related charges for net claims, as we recorded $203 million in 2005 related to hurricanes Katrina, Rita and Wilma and $61 million for additional claims in 2006 predominantly related to hurricane Wilma. The favourable impact on the translated value of U.S. dollar-denominated actuarial liabilities as a result of the stronger Canadian dollar and lower U.S. annuity sales also contributed to the decrease. These factors were partially offset by higher benefits and claims costs associated with business growth and a reduced level of net favourable actuarial liability adjustments in 2006.
     
Taxes   Table 13
                         
(C$ millions, except percentage amounts)   2007     2006     2005  
 
Income taxes
   $ 1,392     $ 1,403     $ 1,278  
 
Other taxes
                        
Goods and services and sales taxes
   $ 208     $ 218     $ 218  
Payroll taxes
     227       217       220  
Capital taxes
     117       107       164  
Property taxes (1)
     97       92       93  
Insurance premium taxes
     41       39       39  
Business taxes
     8       7       9  
 
 
     698       680       743  
 
Total income and other taxes
   $ 2,090     $ 2,083     $ 2,021  
 
Net income before income taxes
   $ 7,025     $ 6,204     $ 4,702  
 
Effective income tax rate (2)
     19.8 %     22.6 %     27.2 %
Effective total tax rate (3)
     27.1 %     30.3 %     37.1 %
 
(1)   Includes amounts netted against non-interest income regarding investment properties.
 
(2)   Income taxes, as a percentage of net income before income taxes.
 
(3)   Total income and other taxes as a percentage of net income before income and other taxes.
Our operations are subject to a variety of taxes, including taxes on income and capital assessed by Canadian federal and provincial governments and taxes on income assessed by the governments of international jurisdictions where we operate. Taxes are also assessed on expenditures and supplies consumed in support of our operations.
2007 vs. 2006
Income tax expense decreased $11 million, or 1%, from a year ago, despite higher earnings before income taxes. The effective tax rate of 19.8% compared favourably to 22.6% a year ago. The lower effective tax rate was largely due to writedowns on the valuation of U.S. sub-prime RMBS and CDOs of ABS reported by our subsidiaries operating in jurisdictions with higher income tax rates, the gain related to the Visa Inc. restructuring, which is taxed at the capital gains tax rate, and a higher level of income from tax-advantaged sources (Canadian taxable corporate dividends).
     Other taxes increased by $18 million from a year ago, largely due to increased payroll taxes reflecting higher staffing levels and higher capital taxes due to an increased Canadian capital tax base on which capital taxes are levied. Increased property taxes reflecting a higher number of branches also contributed to the increase. These factors were partially offset by lower goods and services and sales taxes due to a decrease in the goods and services tax (GST) rate.
     In addition to the income and other taxes reported in our Consolidated Statements of Income, we recorded income taxes of $946 million in 2007 (2006 — $136 million) in Shareholders’ equity, an increase of $810 million, primarily reflecting an increase in unrealized foreign currency translation gains as shown in Note 24 to our Consolidated Financial Statements.
2006 vs. 2005
Income taxes were up in 2006 compared to 2005, largely reflecting higher earnings and the impact of the Enron litigation-related provision recorded in 2005. The effective income tax rate for 2006 decreased 4.6% primarily due to higher earnings reported by our subsidiaries operating in jurisdictions with lower income tax rates, a higher level of income from tax-advantaged sources (Canadian taxable corporate dividends), and the favourable resolution of income tax audits in 2006 related to prior years.
     Other taxes decreased $63 million, largely due to lower capital taxes primarily related to recoveries of capital taxes paid in prior periods and a lower Canadian capital base on which capital taxes are levied.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  49

 

 

     
Results by geographic segment (1)   Table 14
                                                                                                 
    2007     2006     2005  
 
            United     Other                     United     Other                     United     Other        
(C$ millions)   Canada     States     International     Total     Canada     States     International     Total     Canada     States     International     Total  
 
Net interest income
   $ 6,435     $ 412     $ 685     $ 7,532     $ 6,045     $ 108     $ 643     $ 6,796     $ 5,628     $ 608     $ 557     $ 6,793  
Non-interest income
     8,605       4,322       2,003       14,930       7,518       4,397       1,926       13,841       6,878       3,955       1,558       12,391  
 
Total revenue
     15,040       4,734       2,688       22,462       13,563       4,505       2,569       20,637       12,506       4,563       2,115       19,184  
Provision for (recovery of) credit losses
     696       90       5       791       456       (28 )     1       429       433       23       (1 )     455  
Insurance policyholder benefits, claims and acquisition expense
     1,230       474       469       2,173       1,379       683       447       2,509       1,270       809       546       2,625  
Non-interest expense
     7,409       3,405       1,659       12,473       7,056       3,038       1,401       11,495       6,685       3,595       1,077       11,357  
Business realignment charges
     —       —       —       —       —       —       —       —       45       —       —       45  
Income taxes and non-controlling interest
     1,788       (13 )     (242 )     1,533       1,495       13       (61 )     1,447       1,299       (64 )     30       1,265  
 
Net income from continuing operations
   $ 3,917     $ 778     $ 797     $ 5,492     $ 3,177     $ 799     $ 781     $ 4,757     $ 2,774     $ 200     $ 463     $ 3,437  
 
Net income (loss) from discontinued operations
   $ —     $ —     $ —     $ —     $ —     $ (29 )   $ —     $ (29 )   $ —     $ (50 )   $ —     $ (50 )
 
Net income
   $ 3,917     $ 778     $ 797     $ 5,492     $ 3,177     $ 770     $ 781     $ 4,728     $ 2,774     $ 150     $ 463     $ 3,387  
 
(1)   For geographic reporting, our segments are grouped into Canada, United States and Other International. Transactions are primarily recorded in the location that best reflects the risk due to negative changes in economic conditions and prospects for growth due to positive economic changes. This location frequently corresponds with the location of the legal entity through which the business is conducted and the location of our clients. Transactions are recorded in the local currency and are subject to foreign exchange rate fluctuations with respect to the movement of the Canadian dollar.
2007 vs. 2006
Net income in Canada was $3,917 million, up $740 million, or 23%, compared to the prior year. This increase largely reflected strong volume and balance growth in our domestic banking and wealth management businesses and a gain related to the Visa Inc. restructuring. Higher trading results, improved equity origination activity and higher loan syndication activity also contributed to the increase. These factors were partially offset by higher costs reflecting increased business levels and in support of growth initiatives, higher provisions for credit losses and higher credit card customer loyalty reward program costs this year.
     U.S. net income of $778 million was up $8 million, or 1%, from the prior year. Solid revenue growth reflecting the inclusion of our recent acquisitions and improved equity origination and M&A activity was mostly offset by the negative impact of the stronger Canadian dollar on the translated value of our U.S. dollar-denominated earnings, higher costs in support of business growth and higher provision for credit losses, which primarily reflected higher impaired loans in our U.S. residential builder finance business.
     Other international net income of $797 million was up $16 million, or 2%, from 2006, partly due to stronger insurance results reflecting the absence of hurricane-related charges this year and a favourable adjustment related to the reallocation of certain foreign investment capital this year. Growth at RBC Dexia IS also contributed to the increase. These factors were largely offset by lower trading results in certain fixed income businesses as a result of writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS.
2006 vs. 2005
Net income in Canada was $3,177 million, up $403 million, or 15%, compared to 2005. This increase largely reflected strong revenue growth in our wealth management and banking businesses due to our successful execution of growth initiatives, the continuing favourable economic conditions and stronger M&A activity. These factors were partly offset by higher variable compensation on stronger business performance and increased costs in support of business growth.
     U.S. net income of $770 million was up $620 million, or 413%, from 2005 and comprises net income from continuing operations of $799 million and a net loss from discontinued operations of $29 million. U.S. net income from continuing operations was up $599 million, or 300%, compared to 2005 largely reflecting the Enron litigation-related provision and strong trading results in 2006. These factors were partially offset by lower debt originations, lower U.S. annuity sales, the negative impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated income and the gain recorded in the prior year on the sale of LIS in 2005.
     Net loss from discontinued operations of $29 million in 2006 compared to a net loss of $50 million in 2005. The 2006 net loss reflected charges related to the wind down of operations of RBC Mortgage Company. The 2005 net loss largely reflected charges related to the sale and wind down of operations, including the costs of closing RBC Mortgage Company’s Chicago office and certain branches, employee incentive payments and the write down of certain assets.
     Other international net income was up $318 million, or 69%, from 2005, mainly reflecting the lower net estimated hurricane-related charges and income tax amounts, which were largely related to enterprise-funding activities and solid business growth in our European life reinsurance business. These factors were partially offset by lower revenue from property catastrophe reinsurance reflecting our strategic reduction in exposure.
Related party transactions
In the ordinary course of business, we provide normal banking services, operational services and enter into other transactions with associated and other related corporations, including our joint venture entities, on terms similar to those offered to non-related parties.
     We grant loans to directors, officers and other employees at rates normally accorded to preferred clients. In addition, we offer deferred share and other plans to non-employee directors, executives and certain other key employees. For further information, refer to Notes 9 and 29 to our Consolidated Financial Statements.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  50

 

 

QUARTERLY FINANCIAL INFORMATION
RESULTS AND TREND ANALYSIS
Our quarterly earnings, revenue and expenses are impacted by a number of trends and recurring factors which include seasonality, general economic conditions and competition. The following table summarizes our results for the last eight quarters.
     
Quarterly results   Table 15
                                                                 
    2007     2006  
 
(C$ millions, except per share amounts)   Q4     Q3     Q2     Q1     Q4     Q3     Q2     Q1  
 
Net interest income
   $ 1,828     $ 1,965     $ 1,889     $ 1,850     $ 1,731     $ 1,766     $ 1,617     $ 1,682  
Non-interest income
     3,787       3,515       3,780       3,848       3,618       3,440       3,505       3,278  
 
Total revenue
   $ 5,615     $ 5,480     $ 5,669     $ 5,698     $ 5,349     $ 5,206     $ 5,122     $ 4,960  
Non-interest expense
     3,093       3,165       3,148       3,067       2,955       2,861       2,928       2,751  
Provision for credit losses
     263       178       188       162       159       99       124       47  
Insurance policyholder benefits, claims and acquisition expense
     637       343       677       516       611       627       619       652  
 
Net income before income taxes and non-controlling interest in subsidiaries
   $ 1,622     $ 1,794     $ 1,656     $ 1,953     $ 1,624     $ 1,619     $ 1,451     $ 1,510  
Income taxes
     255       349       353       435       342       381       348       332  
Non-controlling interest in net income of subsidiaries
     43       50       24       24       19       44       (25 )     6  
 
Net income from continuing operations
   $ 1,324     $ 1,395     $ 1,279     $ 1,494     $ 1,263     $ 1,194     $ 1,128     $ 1,172  
Net income (loss) from discontinued operations
     —       —       —       —       (1 )     (17 )     (10 )     (1 )
 
Net income
   $ 1,324     $ 1,395     $ 1,279     $ 1,494     $ 1,262     $ 1,177     $ 1,118     $ 1,171  
 
Earnings per share — basic
   $ 1.02     $ 1.07     $ .99     $ 1.16     $ .97     $ .91     $ .86     $ .90  
— diluted
   $ 1.01     $ 1.06     $ .98     $ 1.14     $ .96     $ .90     $ .85     $ .89  
 
Segment net income (loss)
                                                                
Canadian Banking
   $ 899     $ 699     $ 618     $ 771     $ 675     $ 660     $ 511     $ 580  
Wealth Management
     180       177       194       211       164       136       159       145  
U.S. & International Banking
     21       87       67       67       79       82       62       38  
Capital Markets
     186       360       350       396       300       303       414       338  
Corporate Support
     38       72       50       49       45       13       (18 )     71  
 
Net income
   $ 1,324     $ 1,395     $ 1,279     $ 1,494     $ 1,263     $ 1,194     $ 1,128     $ 1,172  
 
Period average USD equivalent of C$1.00 (1)
   $ 1.001     $ .937     $ .874     $ .861     $ .897     $ .896     $ .877     $ .865  
Period-end USD equivalent of C$1.00
     1.059       .937       .901       .850       .890       .884       .894       .878  
 
(1)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
Seasonality
Seasonal factors impact our results in most quarters. The second quarter has fewer days than the other three quarters, resulting in a decrease primarily in net interest income and certain expense items. The third and fourth quarters include the summer months during which market activity frequently slows, negatively impacting the results of our capital markets, brokerage and investment management businesses.
Impact of economic and market conditions
In general, economic conditions remained favourable over most of the last eight quarters and positively impacted our businesses. Economic conditions were negatively impacted in the latter part of 2007, mainly attributable to the U.S. subprime mortgage market concerns. For a further discussion, refer to the Overview of 2007 section.
     The strengthening of the Canadian dollar over the period resulted in lower translated value of our U.S. dollar-denominated earnings, primarily in our wholesale banking business and U.S. retail operations.
Overview and consolidated results
Over the last eight quarters, our results were affected by a number of favourable and unfavourable items or events. Our fourth quarter 2007 results were impacted by the writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS, the gain related to the Visa Inc. restructuring, and higher credit card customer loyalty reward program costs. In the first quarter of 2007 we recorded a favourable adjustment related to the reallocation of foreign investment capital and our insurance business results were negatively impacted by hurricane-related charges of $61 million (before- and after-tax). During the same quarter, we also recorded a $50 million reversal of the general allowance in light of the strong credit quality of our corporate loan portfolio, which partially reflected the favourable credit conditions. Our results over the last eight quarters were also impacted by the acquisition of certain businesses. For further discussion, refer to the Overview of 2007 section.
     Our consolidated net income consistently exceeded $1 billion over the last eight quarters. These strong results largely reflected a general increase in revenue across all our business segments. This positive trend was partially offset by the lower translated value of foreign currency-denominated revenue and earnings as a result of the strengthening of the Canadian dollar against the U.S. dollar during most of the period, with the effects being more pronounced in the most recent quarter.
     Non-interest expense generally increased over the last eight quarters, largely reflecting increased variable compensation on strong business performance and higher costs due to increased business activity volume, acquisitions and higher spending in support of our growth initiatives.
     Provision for credit losses was at a cyclically low level during most of the period, primarily reflecting a generally benign credit environment and favourable corporate recoveries. However, it increased over the past year due to portfolio growth, as well as increasing loss rates and higher impairments, both of which have trended up towards historical averages. In the fourth quarter of 2007, the provision for
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 51

 

 

credit losses increased in our U.S. & International Banking segment due to higher impaired loans, primarily driven by the downturn in the U.S. housing market. The decrease in provisions in the first quarter of 2006 was primarily due to a $50 million reversal of the general allowance in light of the strong credit quality of our corporate loan portfolio at that time.
     PBCAE fluctuated considerably over the period. Although underlying business growth has generally increased PBCAE, there can be significant quarterly volatility resulting from claims experience, actuarial liability adjustments and capital market impacts on equities backing universal life policyholder funds. The impact of the new financial instruments accounting standards implemented in the first quarter of 2007 introduced additional volatility to this line. Other than claims experience and actuarial liability adjustments, these items are predominantly offset in Insurance-related revenue. As well, the first quarter of 2006 was impacted by hurricane-related charges.
     Our effective income tax rate has generally trended downward from 22.0% to 15.7% over the period, despite higher earnings before income taxes. This largely reflected higher income from tax-advantaged sources (Canadian taxable corporate dividends), favourable income tax settlements in the first quarter of 2006 and the second and third quarters of 2007. The fourth quarter of 2007 reflected writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS reported by our subsidiaries operations in jurisdictions with higher income tax rates and a lower tax rate on the gain related to the Visa Inc. restructuring.
     Non-controlling interest in net income of subsidiaries fluctuated over the period, which depends on the net income attributed to third-party investors in entities in which we do not have 100% ownership, but are required to consolidate.
Business segment results
Canadian Banking net income generally increased over the last eight quarters reflecting strong volume growth across most business lines. Margins have decreased slightly over the latter part of 2007, primarily due to strong market competition. Our results in the fourth quarter of 2007 were favourably impacted by the gain related to the Visa Inc. restructuring, which was partly offset by higher credit card customer loyalty reward program costs. Also, the first quarter of 2007 was positively impacted by a favourable adjustment related to the reallocation of foreign investment capital while the first quarter of 2006 was adversely impacted by hurricane-related charges.
     Wealth Management net income has generally trended higher over the last eight quarters, driven largely by strong growth in fee-based client assets across all business lines reflecting new sales, capital appreciation and the recruitment and retention of experienced advisors. This has been partially offset by higher variable compensation commensurate with commission-based revenue and higher costs in support of business growth, including recent acquisitions.
     U.S. & International Banking results were generally stable during the period except for the fourth quarter of 2007. The decrease in earnings in the fourth quarter of 2007 was primarily attributable to the higher provisions in our U.S. residential builder finance loan portfolio reflecting higher impaired loans. In addition, net income was impacted by higher costs in support of business growth, including recent acquisitions and de novo branch openings.
     Capital Markets recorded a general improvement in earnings over the period, with the exception of the fourth quarter of 2007, which was impacted by the writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS over concerns related to the U.S. subprime mortgage market. Throughout 2006 and most of 2007, our diverse business and product offerings, together with business expansions and growing global distribution capabilities, contributed to this positive trend. However, these factors were partially offset by the lower translated value of U.S. dollar- and British pound-denominated earnings resulting from the stronger Canadian dollar.
FOURTH QUARTER 2007 PERFORMANCE
Fourth quarter net income of $1,324 million was up $62 million, or 5%, from a year ago despite the $48 million unfavourable impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated earnings. Diluted EPS were $1.01, up 5%. ROE was 23.0% compared to 23.9% a year ago. The increase was primarily due to a gain on the Visa Inc. restructuring, higher equity derivatives and foreign exchange trading results and solid volume and balance growth in our banking and wealth management businesses. These factors were partly offset by writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS, and an adjustment to increase our credit card customer loyalty reward program costs.
     Total revenue increased $266 million, or 5%, from a year ago, largely reflecting a gain on the Visa Inc. restructuring, higher equity derivatives and foreign exchange trading revenue and continued solid volume and balance growth in our banking and wealth management businesses. The favourable impact of the new financial instruments accounting standards, the inclusion of recent acquisitions and improved M&A activity also contributed to the increase. These factors were partly offset by lower trading revenue in our fixed income businesses reflecting the writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS and an adjustment to increase our credit card customer loyalty reward program costs.
     Non-interest expense increased $138 million, or 5%, from a year ago, largely reflecting higher costs in support of our business initiatives, including higher staffing levels, our recent acquisitions and de novo branch openings. These factors were partially offset by lower variable compensation in Capital Markets due to weaker results.
     Provision for credit losses increased $104 million from a year ago, largely reflecting higher impaired loans in our U.S. residential builder finance business portfolio, primarily driven by the downturn in the U.S. housing market. Higher provisions commensurate with growth in our credit card portfolio and higher impairment in our business portfolio also contributed to the increase.
     PBCAE increased $26 million, or 4%, over the prior year, primarily due to the impact of the new financial instruments accounting standards, increased costs associated with growth in our European life reinsurance business as well as less favourable claims experience in the current period. These factors were partly offset by reduced expenses associated with lower U.S. annuity sales, a higher level of favourable net actuarial liability adjustments, and the favourable impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated expenses.
Royal Bank of Canada: Annual Report 2007
52  Management’s Discussion and Analysis

 

 

     
BUSINESS SEGMENT RESULTS
    
 
    
Results by business segment
  Table 16
                                                                 
    2007     2006     2005  
                    U.S. &                                
    Canadian     Wealth     International     Capital     Corporate                    
(C$ millions)   Banking     Management     Banking     Markets(1)     Support(1)     Total     Total     Total  
 
Net interest income
   $ 6,353     $ 427     $ 1,031     $ 453     $ (732 )   $ 7,532     $ 6,796     $ 6,793  
Non-interest income
     6,168       3,565       884       3,936       377       14,930       13,841       12,391  
 
Total revenue
   $ 12,521     $ 3,992     $ 1,915     $ 4,389     $ (355 )   $ 22,462     $ 20,637     $ 19,184  
Non-interest expense
     5,285       2,902       1,481       2,769       36       12,473       11,495       11,357  
Provision for (recovery of) credit losses
     788       1       109       (22 )     (85 )     791       429       455  
Insurance policyholder benefits, claims and acquisition expense
     2,173       —       —       —       —       2,173       2,509       2,625  
Business realignment charges
     —       —       —       —       —       —       —       45  
 
Net income before income taxes and non-controlling interest in net income of subsidiaries
   $ 4,275     $ 1,089     $ 325     $ 1,642     $ (306 )   $ 7,025     $ 6,204     $ 4,702  
Net income
   $ 2,987     $ 762     $ 242     $ 1,292     $ 209     $ 5,492     $ 4,757     $ 3,437  
 
Return on equity (ROE) (2)
     34.3 %     32.4 %     6.9 %     26.6 %     6.7 %     24.6 %     23.5 %     18.0 %
Return on risk capital (RORC) (2)
     45.5 %     65.1 %     11.7 %     32.5 %     n.m.       37.4 %     36.7 %     29.3 %
Average assets (3)
   $ 220,000     $ 16,600     $ 39,700     $ 311,200     $ (6,500 )   $ 581,000     $ 502,300     $ 447,100  
 
(1)   Net interest income, total revenue and net income before income taxes are presented in Capital Markets on a taxable equivalent basis. The taxable equivalent basis adjustment is eliminated in the Corporate Support segment. For a further discussion, refer to the How we measure and report our business segments section.
 
(2)   Average risk capital and the Return on risk capital are key performance measures. For further details, refer to Key performance and non-GAAP measures section.
 
(3)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
n.m.   not meaningful
Canadian Banking
Net income increased $561 million, or 23%, from a year ago. The increase primarily reflected strong growth across all our business lines as well as a gain related to the Visa Inc. restructuring, partially offset by higher costs in support of business growth, increased provision for credit losses and higher credit card customer loyalty reward program costs this year. Our prior year results also included the hurricane-related charges and the receipt of a fee related to the termination of an agreement, whereas this year we included a favourable adjustment related to the reallocation of certain foreign investment capital.
Wealth Management
Net income for the year of $762 million increased $158 million, or 26%, from a year ago. The increase was largely due to strong earnings growth across all our business lines reflecting the ongoing successful execution of our growth initiatives and generally favourable market conditions. We recorded a foreign exchange translation gain on certain deposits in the current year related to the implementation of the new financial instruments accounting standards.
U.S. & International Banking
Net income decreased $19 million, or 7%, from the prior year. The decrease was largely attributable to increased provision for credit losses, primarily reflecting higher impaired loans in our U.S. residential builder finance business. This was partially offset by strong business growth in RBC Dexia IS, as well as higher loan and deposit growth in the U.S. reflecting the inclusion of our acquisitions of Flag and the AmSouth branches, de novo branch openings and business expansion. Our results also reflected higher costs in support of business growth and a loss on the restructuring of our U.S. banking investment portfolio this year.
Capital Markets
Net income decreased $63 million, or 5%, compared to a year ago largely due to the writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS in our Structured Credit business. The negative impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated earnings also contributed to the decrease. These factors were partially offset by broad-based revenue growth in many other businesses.
Corporate Support
Net income of $209 million for the year included income tax amounts largely related to enterprise funding activities that were not allocated to the business segments and favourable income tax settlements related to prior years. These factors were partially offset by the mark-to-market losses on derivatives relating to certain economic hedges, a cumulative adjustment for losses resulting from the fair valuing of certain derivatives that did not qualify for hedge accounting and higher capital taxes that were not allocated to the business segments.
(BAR CHART)
(BAR CHART)
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  53

 

 

HOW WE MEASURE AND REPORT OUR BUSINESS SEGMENTS
Our management reporting framework is intended to measure the performance of each business segment as if it were a stand-alone business and reflect the way that business segment is managed. This approach is intended to ensure that our business segments’ results reflect all relevant revenue and expenses associated with the conduct of their business and it depicts how management views those results.
     The following highlights the key aspects of how our business segments are managed and reported:
•   Canadian Banking reported results include securitized Canadian residential mortgage and credit card loans and related amounts for income and provision for credit losses. The securitized residential mortgage and credit card loans included as at October 31, 2007 were $19 billion and $4 billion, respectively
 
•   Wealth Management reported results include additional disclosures in U.S. dollars for its U.S. & International Wealth Management business line, as we review and manage the results of this business line largely in U.S. dollars
 
•   U.S. & International Banking reported results include additional disclosure in U.S. dollars for its Banking business line, as we review and manage the results of this business line largely on a U.S. dollar basis
 
•   Capital Markets results are reported on a taxable equivalent basis (teb), which grosses up Net interest income from certain tax-advantaged sources (Canadian taxable corporate dividends) to their effective taxable equivalent value with a corresponding offset recorded in the provision for income taxes. This increases comparability between taxable and tax-advantaged sources of revenue
 
•   Corporate Support results include all enterprise level activities that are undertaken for the benefit of the organization that are not allocated to our four business segments, such as enterprise funding, securitizations and net charges associated with unattributed capital. The reported results of the Corporate Support segment also reflect consolidation adjustments, including the elimination of the teb adjustments recorded in Capital Markets.
Key methodologies
The following outlines the key methodologies and assumptions used in our management reporting framework. These assumptions and methodologies are periodically reviewed by management to ensure they remain valid.
Expense allocation
In order to ensure that our business segments’ results include expenses associated with the conduct of their business, we allocate costs incurred or services provided by GTO and Global Functions, which are directly undertaken or provided on the business segments’ behalf. For other costs not directly attributable to our business segments, including overhead costs and other indirect expenses, we use our management reporting framework for allocating these costs to each business segment in a manner that reflects the underlying benefits.
Capital attribution
Our framework also assists in the attribution of capital to our business segments in a manner that is intended to consistently measure and align economic costs with the underlying benefits and risks associated with the activities of each business segment. The amount of capital assigned to each business segment is referred to as attributed capital. Unattributed capital and associated net charges, are reported in Corporate Support.
     The capital attribution methodologies, detailed in the Capital management section, involve a number of assumptions and estimates that involve judgment and are revised periodically. Any changes to these factors directly impact other measures such as business segment return on average common equity and return on average risk capital.
Funds transfer pricing
Our funds transfer pricing methodology is used to allocate interest income and expense to each business segment. This allocation considers the interest rate risk, liquidity risk and regulatory requirements of our business segments. Our business segments may retain certain interest rate exposures, subject to management approval, that would be expected in the normal course of operations. Other activities conducted between our business segments are generally conducted at market rates.
Taxable equivalent basis (teb)
Similar to many other institutions, we analyze income from certain tax-advantaged sources (Canadian taxable corporate dividends) on a taxable equivalent basis. Under this approach, we gross up revenue from certain tax-advantaged sources, which currently only includes our Canadian taxable corporate dividends recorded in Net interest income, to their effective taxable equivalent value with a corresponding offset recorded in the provision for income taxes. We record teb adjustments in Capital Markets and record elimination adjustments in Corporate Support. We believe these adjustments are useful and reflect how Capital Markets manages its business since it increases the comparability of revenue and related ratios across taxable and our principal tax-advantaged sources of revenue. The use of teb adjustments and measures may not be comparable to similar GAAP measures or similarly adjusted amounts at other financial institutions. The teb adjustment for 2007 was $332 million (2006 — $213 million, 2005 — $109 million).
Changes made in 2007
The following highlights the key changes we made to our management reporting framework and business segments during the year. All segment results have been revised accordingly for 2006 and 2005. These changes did not have an impact on our consolidated results or disclosure, unless otherwise noted.
•   We revised the assets under administration — RBC Dexia IS amount for 2006 to reflect the total assets under administration amount reported by our joint venture. We had previously disclosed only the total assets under custody amount related to RBC Dexia IS.
 
•   We revised our definitions of assets under administration and assets under management to better align them with our business-specific practices. This change did not impact the amounts reported for 2006 and 2005.
 
•   We reclassified certain amounts reported in Capital Markets from Interest income to Interest expense. There was no impact to Net interest income as a result of this reclassification.
 
•   We reclassified certain amounts reported in Corporate Support related to interest settlements on swaps in fair value hedge relationships from Non-interest income to Net interest income. This reclassification did not impact results for 2006 and 2005.
 
•   We reclassified certain deposits reported in Capital Markets and U.S. & International Banking related to RBC Dexia IS, in accordance with the Q2 2007 business segment realignment.
 
•   We reclassified expenses related to internally developed software from Non-interest expense — Other to more specific Non-interest expense lines. All related comparative amounts were updated to reflect this reclassification, which impacted the Corporate Support segment only, and had no impact on total Non-interest expense.
 
•   Certain amounts related to trustee services within Canadian Banking were reclassified from Non-interest income — Investment management and custodial fees to Net interest income to better reflect their nature.
Royal Bank of Canada: Annual Report 2007
54  Management’s Discussion and Analysis

 

 

IMPACT OF FOREIGN EXCHANGE RATES ON OUR BUSINESS SEGMENTS
The translated value of our business segment results is impacted by fluctuations in the respective exchange rates relative to the Canadian dollar. Wealth Management, U.S. & International Banking and Capital Markets each have significant U.S. dollar-denominated operations, while U.S. & International Banking has material Euro-denominated results related to RBC Dexia IS, and Capital Markets has significant British pound-denominated operations.
     In 2007, the Canadian dollar appreciated 4% on average relative to the U.S. dollar and depreciated 5% on average relative to both the British pound and Euro compared to a year ago. As a result of the impact of the changes in the respective exchange rates from last year, Wealth Management net income was down $9 million, U.S. & International Banking net income was up $4 million, while Capital Markets net income was down $30 million. For further discussion, refer to the applicable business segment results section.
KEY PERFORMANCE AND NON-GAAP MEASURES
Key performance measures
Return on equity and Return on risk capital
We measure and evaluate the performance of our consolidated operations and each business segment using a number of financial metrics such as net income, return on average common equity (ROE) and return on average risk capital (RORC). We use ROE and RORC as a measure of return on total capital invested in our businesses. RORC does not have a standardized meaning under GAAP and may not be comparable to similar measures used by other financial institutions.
     Our consolidated ROE calculation is based on net income available to common shareholders divided by total average common equity for the period. Business segment ROE calculations are based on annualized segment net income available to common shareholders divided by average attributed capital for the period. For each segment, average attributed capital is based on attributed risk capital and amounts invested in goodwill and intangibles (1).
     The attribution of capital involves the use of assumptions, judgments and methodologies that are regularly reviewed and revised by management as necessary. The attribution of risk capital is based on certain assumptions, judgments and models that quantify economic risks as described in the Economic Capital section. Changes to such assumptions, judgments and methodologies can have a material effect on the segment ROE and RORC information that we report. Other companies that disclose information on similar attributions and related return measures may use different assumptions, judgments and methodologies.
     RORC is used to measure returns on capital required to support the risks related to ongoing operations. Our RORC calculations are based on net income available to common shareholders divided by attributed risk capital (which excludes goodwill and intangibles and unattributed capital). The business segment ROE and RORC measures are viewed as useful measures by management for supporting investment and resource allocation decisions because they adjust for certain items that may affect comparability between business segments and certain competitors. The following table provides a summary of the ROE and RORC calculations.
(1)   For internal allocation and measurement purposes, total attributed capital is deemed by management to comprise amounts necessary to support the risks inherent in the businesses (risk capital) and amounts related to historical investments (goodwill and intangibles). Total risk capital and goodwill and intangibles are referred to as Attributed capital as well as Economic Capital. The difference between total average common equity and average attributed capital is classified as Unattributed capital and reported in Corporate Support for segment reporting purposes.
     
Calculation of Return on equity and Return on risk capital
  Table 17
                                                                 
    2007     2006     2005  
                    U.S. &                                
(C$ millions, except for percentage amounts) (1), (2)   Canadian
Banking		     Wealth
Management		     International
Banking		     Capital
Markets		     Corporate
Support		     Total     Total     Total  
 
Net income available to common shareholders
   $ 2,953     $ 753     $ 228     $ 1,272     $ 198     $ 5,404     $ 4,668     $ 3,349  
 
Average risk capital (2)
   $ 6,500     $ 1,150     $ 1,950     $ 3,900     $ 950     $ 14,450     $ 12,750     $ 11,450  
Add: Unattributed capital
     —       —       —       —       2,000       2,000       2,500       2,300  
Goodwill and intangible capital
     2,100       1,150       1,400       900       —       5,550       4,650       4,850  
Average equity (3)
   $ 8,600     $ 2,300     $ 3,350     $ 4,800     $ 2,950     $ 22,000     $ 19,900     $ 18,600  
 
Return on equity (ROE)
     34.3 %     32.4 %     6.9 %     26.6 %     6.7 %     24.6 %     23.5 %     18.0 %
Return on risk capital (RORC)
     45.5 %     65.1 %     11.7 %     32.5 %     n.m.       37.4 %     36.7 %     29.3 %
 
(1)   Average risk capital, Goodwill and intangible capital, and Average equity represent rounded figures. These amounts are calculated using methods intended to approximate the average of the daily balances for the period. ROE and RORC measures are based on actual balances before rounding.
 
(2)   Average risk capital includes Credit, Market (trading and non-trading), Insurance, Operational and Business and fixed assets risk capital. For further details refer to the Capital management section.
 
(3)   The amounts for the segments are also referred to as attributed capital.
 
n.m.   not meaningful
Non-GAAP measures
Given the nature and purpose of our management reporting framework, we use certain non-GAAP financial measures, which are not defined nor do they have standardized meaning under GAAP. Hence these reported amounts and related ratios are not necessarily comparable with similar information reported by other financial institutions.
2007 Defined operating leverage
Our defined operating leverage refers to the difference between our revenue growth rate (as adjusted) and non-interest expense growth rate (as adjusted). Revenue is presented on a taxable equivalent basis, while the impact of consolidated VIEs is excluded, as they have no material impact on our earnings. Accounting adjustments related to the new financial instruments accounting standards are also excluded from revenue as they give rise to volatility, primarily relating to unrealized gains and losses arising from fair valuing of the instruments and are not viewed as a measure of economic performance. Global Insurance results are excluded, as certain changes in revenue can be largely offset in Insurance policyholder benefits, claims and acquisition expense, which is not captured in our defined operating leverage calculation.
     The following table shows the defined operating leverage ratio calculation.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  55

 

 

     
2007 Defined operating leverage
  Table 18
                         
(C$ millions, except percentage amounts)   2007     2006     Change  
 
Total revenue
   $ 22,462     $ 20,637          
Add: teb adjustment
     332       213          
Less: Revenue related to VIEs
     31       (7 )        
Less: Global Insurance revenue
     3,192       3,348          
Less: Impact of the new financial instruments accounting standards (1)
     83       —          
Total revenue (adjusted)
   $ 19,488     $ 17,509       11.3 %
 
Non-interest expense
   $ 12,473     $ 11,495          
Less: Global Insurance-related non-interest expense
     537       517          
 
Non-interest expense (adjusted)
   $ 11,936     $ 10,978       8.7 %
 
Defined operating leverage
                     2.6 %
 
(1)   Excludes the impact of the new financial instruments accounting standards related to Global Insurance.
Consolidated revenue and Insurance-related results excluding the impact of the new financial instruments accounting standards and hurricane-related charges
In 2007 and 2006, there were certain items that impacted Total consolidated revenue, Global Insurance and Insurance-related results. Management believes that identifying and adjusting for these items enhances the comparability of our results, and enables a more meaningful comparison of our financial performance with certain other financial institutions that make similar adjustments.
     The following table provides a reconciliation of consolidated revenue, Global Insurance and Insurance-related results excluding the impacts of the new financial instruments accounting standards and the hurricane-related charges.
         
Consolidated revenue, Global Insurance and Insurance-related results excluding the noted items
   Table 19
                                                                 
    October 31, 2007     October 31, 2006  
                    Insurance     Insurance                     Insurance     Insurance  
                    premiums,     policyholder                     premiums,     policyholder  
            Global     investment     benefits, claims             Global     investment     benefits, claims  
    Consolidated     Insurance     and     and acquisition     Consolidated     Insurance     and     and acquisition  
(C$ millions)   revenue(1)     revenue(2)     fee income(1)     expense(1)     revenue (1)     revenue (2)     fee income (1)     expense (1)  
 
GAAP reported amounts
   $ 22,462     $ 3,192     $ 3,152     $ 2,173     $ 20,637     $ 3,348     $ 3,348     $ 2,509  
Exclude: Impact of the new financial instruments accounting standards
     77       160       160       154       —       —       —       —  
Hurricane-related charges
     —       —       —       —       —       —       —       (61 )
 
Amounts excluding the noted items
   $ 22,539     $ 3,352     $ 3,312     $ 2,327     $ 20,637     $ 3,348     $ 3,348     $ 2,448  
 
(1)   For further details, refer to the Financial performance section.
 
(2)   For further details, refer to the Canadian Banking section.
Royal Bank of Canada: Annual Report 2007
56  Management’s Discussion and Analysis

 

 

CANADIAN BANKING
Canadian Banking comprises our domestic personal and business banking operations, certain retail investment businesses and our global insurance operations. This segment includes Personal Financial Services, Business Financial Services, Cards and Payment Solutions, and Global Insurance.
     Canadian Banking provides a broad suite of financial products and services to over 14 million individual and business clients through our extensive branch, automated teller machine (ATM), online and telephone banking networks, as well as through a large number of proprietary sales professionals in addition to a wide-ranging third-party network of independent insurance distributors.
     We have top rankings in market share for most retail product categories and are the largest Canadian bank-owned insurer.
Highlights
•   We launched new and innovative products to better serve our clients through the introduction of a new personal banking suite that includes several client-centric features, such as multi-product rebates, and a new high-interest online savings account.
 
•   We strengthened our leading market position in personal lending, driven by 12% growth in residential mortgages.
 
•   We continued to expand and upgrade our distribution network. We opened 30 bank branches and 12 insurance offices in Canada during the year.
Economic and market review
In Canada, strong economic growth, in part reflecting solid consumer and business spending in the early part of the year, weakened moderately in the latter part of the year, primarily due to slowing U.S. demand and a tightening of credit conditions as a result of the U.S. subprime mortgage market concerns. Nonetheless, robust domestic demand, largely underpinned by favourable labour market conditions, solid business investment and continued strong Canadian housing market activities, contributed to volume growth in all our businesses, particularly in the home equity lending and retail investment businesses. Competition in the personal deposits market remained strong from both traditional and niche financial institutions.
     
Canadian Banking financial highlights   Table 20
                         
(C$ millions, except number of and percentage amounts)   2007     2006     2005  
 
Net interest income
   $ 6,353     $ 5,816     $ 5,233  
Non-interest income
     6,168       5,880       5,765  
Total revenue
   $ 12,521     $ 11,696     $ 10,998  
Non-interest expense
     5,285       5,027       4,830  
Provision for credit losses (PCL)
     788       604       542  
Insurance policyholder benefits, claims and acquisition expense
     2,173       2,509       2,625  
Net income before income taxes and non-controlling interest in subsidiaries
   $ 4,275     $ 3,556     $ 2,994  
Net income
   $ 2,987     $ 2,426     $ 2,007  
 
Key ratios
                        
Return on equity (1)
     34.3 %     30.1 %     26.3 %
Return on risk capital (1)
     45.5 %     39.9 %     36.3 %
Net interest margin (2)
     3.17 %     3.22 %     3.21 %
Operating leverage (Banking-related operations) (3)
     6.5 %     4.4 %     5.8 %
Selected average balance sheet information (4)
                        
Total assets (5)
   $ 220,000     $ 199,200     $ 181,100  
Total earning assets (5)
     200,400       180,500       163,200  
Loans and acceptances (5)
     200,000       179,700       160,700  
Deposits
     147,100       139,200       132,500  
Attributed capital (1)
     8,600       8,000       7,550  
Risk capital (1)
     6,500       6,050       5,450  
Other information
                        
Assets under administration
   $ 53,300     $ 44,600     $ 33,900  
Number of employees (full-time equivalent)
     25,813       24,828       23,794  
Credit information
                        
Gross impaired loans as a percentage of average net loans and acceptances
     .35 %     .33 %     .31 %
Specific PCL as a percentage of average net loans and acceptances
     .39 %     .34 %     .34 %
 
Banking-related operations (6)
                        
Total revenue
   $ 9,329     $ 8,348     $ 7,687  
Provision for credit losses
     788       604       542  
Non-interest expense
     4,748       4,510       4,329  
Net income
     2,545       2,124       1,852  
Global insurance
                        
Total revenue
   $ 3,192     $ 3,348     $ 3,311  
Insurance policyholder benefits, claims and acquisition expense
     2,173       2,509       2,625  
Non-interest expense
     537       517       501  
Net income
     442       302       155  
 
(1)   Segment Return on equity, Average risk capital and Return on risk capital are key performance measures. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. For further discussion, refer to the Key performance and non-GAAP measures section.
 
(2)   Net interest margin (NIM) is calculated as Net interest income divided by Average total earning assets. Average total earning assets are calculated using methods intended to approximate the average earning asset balances for the period.
 
(3)   Defined as the difference between revenue growth rate and non-interest expense growth rate for Banking-related operations.
 
(4)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(5)   Total assets, Total earning assets, and Loans and acceptances include average securitized residential mortgage and credit card loans for the year of $19 billion and $4 billion, respectively (2006 — $15 billion and $4 billion; 2005 — $11 billion and $4 billion).
 
(6)   The banking-related operations of Canadian Banking comprise Personal Financial Services, Business Financial Services, and Cards and Payment Solutions.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 57

 

 

(BAR CHART)
Financial performance
2007 vs. 2006
Net income increased $561 million, or 23%, from a year ago. The increase primarily reflected strong growth across all our business lines as well as a $326 million ($269 million after-tax) gain related to the Visa Inc. restructuring, partially offset by higher costs in support of business growth, increased provision for credit losses and higher credit card customer loyalty reward program costs, reflecting a $121 million ($79 million after-tax) liability adjustment this year as compared to $72 million ($47 million after-tax) in the prior year. Our prior year results also included the hurricane-related charges, and the receipt of a fee related to the termination of an agreement, whereas this year we included a favourable adjustment related to the reallocation of certain foreign investment capital.
     Average assets increased $21 billion, or 10%, over the prior year. The increase was largely attributable to strong loan growth, underpinned by our successful execution of growth initiatives, robust domestic demand and continued solid Canadian housing market activities. Average deposits were up $8 billion, or 6%, from a year ago, mainly due to growth in business deposits reflecting high liquidity within Canadian businesses.
Banking-related operations
Banking-related operations net income was up $421 million, or 20%, compared to the prior year. The increase was primarily due to solid growth across all business lines and a gain related to the Visa Inc. restructuring. These factors were partially offset by higher costs in support of business growth, increased provision for credit losses, the receipt of a fee related to the termination of an agreement in the prior year, and higher credit card customer loyalty reward program costs this year.
     Total revenue was up $981 million, or 12%, over the prior year. The increase was largely attributable to strong volume growth across all business lines, and the gain related to the Visa Inc. restructuring. These factors were partly offset by the receipt of a fee related to the termination of an agreement in the prior year and higher credit card customer loyalty reward program costs this year.
     Net interest margin decreased 5 bps from a year ago, primarily reflecting the impact of changes in our product mix.
     Non-interest expense increased $238 million, or 5%, compared to a year ago. The increase was largely attributable to higher costs in support of business growth, including a 4% increase in sales and service personnel, or approximately 900 staff, and de novo branch expansion, as well as higher costs associated with system development, professional fees and sundry losses.
     Provision for credit losses increased $184 million, or 30%, from last year, which had been at a cyclically low level, and has trended up towards the historical average this year. The increase was mainly attributable to higher provisions in our business, credit cards and personal loan portfolios, reflecting higher loss rates and portfolio growth.
Global Insurance
Global Insurance net income increased $140 million, or 46%, compared to the prior year. The increase was primarily related to the property catastrophe reinsurance business, reflecting the hurricane-related charges in the prior year, and a favourable adjustment related to the reallocation of certain foreign investment capital this year, which was partially offset by lower income from this business as we exited this business completely this year. A higher level of favourable net actuarial liability adjustments and solid growth in our European life reinsurance business also contributed to the increase. For a detailed discussion regarding Insurance policyholder benefits, claims and acquisition expense, refer to the Global Insurance business line discussion.
2006 vs. 2005
Net income increased $419 million, or 21%, from 2005. The increase primarily reflected solid revenue growth in our banking businesses and lower hurricane-related charges in 2006. These factors were partially offset by increased costs in support of business growth and higher provision for credit losses partly due to loan growth and lower recoveries.
Banking-related operations
Banking-related operations net income increased $272 million, or 15%, from 2005, largely reflecting solid revenue growth across all business lines. The increase in net income was partly offset by increased costs in support of business growth and higher provision for credit losses.
     Total revenue increased $661 million, or 9%, from 2005. The increase was mainly due to strong volume growth across all business lines, and improved deposit and investment spreads, underpinned by our successful execution of growth initiatives and favourable economic conditions.
     Net interest margin increased 1 bp compared to 2005, primarily reflecting improved spreads on deposits and investment products.
     Non-interest expense increased $181 million, or 4%, primarily due to higher levels of sales and service personnel and infrastructure costs in our distribution network and increased marketing costs in support of business growth.
     Provision for credit losses increased $62 million, or 11%, largely reflecting higher provisions in our personal loan portfolio, and lower recoveries in our agriculture loan portfolio in 2006. In 2005, we included our 50% proportionate share of a provision recorded at Moneris.
Global Insurance
Global Insurance net income increased $147 million compared to 2005, largely reflecting a $142 million reduction in hurricane-related charges in 2006. In addition, business growth associated with Canadian life business and European life reinsurance business, as well as improved claims experience in our Canadian property and casualty business contributed to the increase. These factors were partially offset by lower revenue from property catastrophe reinsurance business reflecting our strategic reduction in exposure. For a detailed discussion regarding Insurance-related revenue and Insurance policyholder benefits, claims and acquisition expense, refer to the Financial performance section.
2008 Outlook and priorities
Canadian economic growth is expected to weaken in 2008 due to tighter credit conditions, though credit growth should continue to be supported by rising domestic demand amid expanding labour markets and solid business investment. We will remain focused on new client acquisition and growth in high-value markets, simplifying processes as well as augmenting our strengths in distribution capabilities, product breadth and integration, and client analytics to provide superior client service.
Key strategic priorities for 2008
•   Deliver a superior client experience to help clients achieve financial success, allowing us to retain and grow their business.
 
•   Continue to improve our processes and revise our business models to make it easier for our clients to do business with us.
 
•   Focus on delivering relevant advice and solutions to attract new clients in specific markets, geographies and life stages.
Royal Bank of Canada: Annual Report 2007
58 Management’s Discussion and Analysis

 

 

BUSINESS LINE REVIEW
Personal Financial Services
Personal Financial Services focuses on meeting the needs of our individual clients at every stage of their lives through a wide range of lending and investment products and services, including home equity financing, lines of credit, personal loans, savings and chequing accounts, guaranteed investment certificates (GICs), mutual funds and self-directed brokerage accounts. We have the largest retail banking network in Canada with 1,146 branches and 3,946 ATMs. In addition, we have more than 75 private bankers and 1,700 sales specialists. We also rank first or second in market share for most personal banking products.
Financial performance
Total revenue increased $461 million, or 10%, over the prior year. The increase largely reflected strong volume growth in home equity lending and retail investments, and improved spreads across most products. Higher mutual fund distribution fees, reflecting a 18% growth in mutual fund balances as a result of strong net sales and capital appreciation also contributed to the increase.
     Average residential mortgage balances and personal loans were each up by 12% over the prior year, supported by relatively low interest rates in a historical context, strong labour market conditions and continued solid Canadian housing market activities. Average personal deposit balances increased 6% from a year ago, notwithstanding an increasingly competitive market, in part driven by the success of our recently launched high-interest online savings account.
     
Selected highlights   Table 21
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 5,082     $ 4,621     $ 4,181  
Other information
                        
Residential mortgages (1)
     113,200       100,800       89,700  
Personal loans (1)
     38,700       34,600       30,500  
Personal deposits (1)
     35,500       33,600       32,900  
Personal GICs (1)
     57,900       57,000       57,200  
Branch mutual fund balances
     66,900       56,500       46,600  
AUA — Self-directed brokerage
     28,300       23,200       19,800  
New accounts opened (thousands) (2)
     1,066       769       740  
Number of:
                        
Branches
     1,146       1,117       1,104  
Automated teller machines
     3,946       3,847       3,906  
 
(1)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(2)   Deposit accounts only.
(BAR CHART)
BUSINESS FINANCIAL SERVICES
Business Financial Services offers a wide range of lending, leasing, deposit, investment and transaction products and services to small and medium-sized businesses, commercial, farming and agriculture clients across Canada. We also provide trade-related products and services to Canadian and international clients to assist them in the conduct of their import and export operations domestically and around the globe. Our extensive business banking network includes approximately 100 business banking centres and 2,000 business account managers, and our strong commitment to our clients has resulted in leading market share in business loans and deposits.
Financial performance
Total revenue increased $160 million, or 7%, over the prior year. The increase was largely attributable to solid growth in business loans and deposits, partially offset by lower spreads on deposits.
Average business loans grew by 7% and average business deposits increased 10%, primarily driven by continued solid business spending and high liquidity within Canadian businesses.
     
Selected highlights   Table 22
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 2,301     $ 2,141     $ 2,011  
Other information (average) (1)
                        
Business loans (2)
     36,900       34,400       31,700  
Business deposits (3)
     53,700       48,600       42,400  
 
(1)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(2)   Includes small business loans treated as retail and wholesale loans.
 
(3)   Includes GIC balances.
(BAR CHART)
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 59

 

 

CARDS AND PAYMENT SOLUTIONS
Cards and Payment Solutions provides a wide array of convenient and customized credit cards and related payment products and solutions. In addition, this business line includes our 50% interest in Moneris, the merchant card processing joint venture with the Bank of Montreal.
     We have over 5 million credit card accounts and have an approximately 20% market share of Canada’s credit card purchase volume.
Financial performance
Total revenue increased $360 million, or 23%, compared to the prior year. The increase largely reflected a $326 million ($269 million after-tax) gain related to the Visa Inc. restructuring. Continued solid growth in credit card balances and transaction volumes also contributed to the increase. These factors were partially offset by the receipt of a fee related to the termination of an agreement in the prior year, as well as higher credit card customer loyalty reward program costs this year.
     
Selected highlights   Table 23
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 1,946     $ 1,586     $ 1,495  
Other information
                        
Average credit card balances (1)
     11,200       9,900       8,800  
Net purchase volumes
     47,200       41,500       36,100  
 
(1)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
(BAR CHART)
GLOBAL INSURANCE
Global Insurance offers a wide range of life, creditor, health, travel, home and auto insurance products and services to individual and business clients in Canada and the U.S., as well as reinsurance for clients around the world. These products and services are offered through a wide variety of distribution channels, including telephone, independent brokers, travel agents, career sales force, Internet and retail insurance offices.
     We are the largest Canadian bank-owned insurer, with products distributed through more than 17,000 independent brokers and more than 650 career sales representatives in North America. Our Canadian insurance business holds lead positions in creditor, travel and individual living benefits insurance products, and has a significant presence in life, home and auto insurance. We are a preferred provider of protection, asset accumulation and retirement solutions in the U.S.
Financial performance
Global Insurance net income increased $140 million, or 46%, compared to the prior year. The increase was primarily related to the property catastrophe reinsurance business, reflecting the hurricane-related charges in the prior year, and a favourable adjustment related to the reallocation of certain foreign investment capital this year, which was partially offset by lower income from this business as we exited this business completely this year. A higher level of favourable net actuarial liability adjustments and solid growth in our European life reinsurance business also contributed to the increase.
     Total revenue decreased $156 million, or 5%, from a year ago. Excluding the impact of the new financial instruments accounting standards, total revenue increased $4 million from the prior year. The increase was largely attributable to growth in our European life reinsurance and Canadian businesses, and a favourable adjustment related to the reallocation of certain foreign investment capital this year. These factors were largely offset by lower U.S. annuity sales mainly due to lower long-term interest rates and lower revenue from our property catastrophe reinsurance operations, which we exited completely this year. For a reconciliation of Global Insurance revenue excluding the impact of the new financial instruments accounting standards, refer to the Key performance and non-GAAP measures section.
     Gross insurance premiums and deposits were up $54 million, or 2%, primarily reflecting new sales growth and stronger client retention, partially offset by a decline in U.S. annuity sales.
     Non-interest expense was up $20 million, or 4%, from a year ago, primarily reflecting higher project-related spending and other costs in support of business growth.
     Insurance policyholder benefits, claims and acquisition expense (PBCAE) decreased $336 million, or 13%, from the prior year. Excluding the impact of the new financial instruments accounting standards and the prior year hurricane-related charges, PBCAE decreased $121 million, or 5%, over last year. The decrease was largely attributable to the impact of lower U.S. annuity sales and a higher level of favourable net actuarial liability adjustments this year, which included cumulative valuation adjustments of $92 million relating to prior periods. These factors were partially offset by increased costs commensurate with growth in our European life reinsurance and Canadian businesses. For a reconciliation of PBCAE excluding the
     
Selected highlights   Table 24
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 3,192     $ 3,348     $ 3,311  
Non-interest expense
     537       517       501  
Insurance policyholder benefits, claims and acquisition expense
     2,173       2,509       2,625  
Net income
     442       302       155  
Other information
                        
Gross insurance premiums and deposits
     3,460       3,406       3,288  
Insurance claims and policy benefit liabilities
     7,283       7,337       7,117  
 
(BAR CHART)
Royal Bank of Canada: Annual Report 2007
60 Management’s Discussion and Analysis

 

 

impact of the new financial instruments accounting standards, refer to the Key performance and non-GAAP measures section.
     Insurance claims and policy benefit liabilities decreased $54 million, or 1%, over the prior year. The decrease primarily reflected the impact of a stronger Canadian dollar on the translated value of our U.S. dollar-denominated liabilities, lower property catastrophe reinsurance liabilities, net payments of claims related to hurricanes, and a net decrease in life and health insurance liabilities reflecting changes to actuarial assumptions and model enhancements. These factors were largely offset by increased costs commensurate with business growth and the impact of the new financial instruments accounting standards.
 WEALTH MANAGEMENT
Wealth Management comprises businesses that directly serve the growing wealth management needs of affluent and high net worth clients in Canada, the U.S. and outside North America, and businesses that provide asset management and trust products through RBC and external partners. This segment comprises Canadian Wealth Management, U.S. & International Wealth Management and Global Asset Management.
Highlights
•   Wealth Management was created in February 2007 to focus on extending our leadership position in Canada and aggressively growing in the U.S. and international markets.
 
•   The fastest growing segment in Canadian wealth management continues to be high net worth clients (households with more than $1 million in investable assets).
 
•   Our Canadian full-service brokerage business was the first in the Canadian industry to surpass $150 billion in client assets under administration.
 
•   We led the Canadian mutual fund industry in net sales of long-term funds for the 16th consecutive calendar quarter.
 
•   We continued to grow our U.S. full-service brokerage business through the acquisition of J.B. Hanauer & Co. (J.B. Hanauer).
 
•   We established international wealth management offices in several cities, including Mexico City, Beijing and Santiago.
Economic and market review
In 2007, economic growth was solid, underpinned by a relatively favourable interest rate environment, strong employment levels and higher wages, and a solid yet moderating housing market, which contributed to increased demand for wealth management products. The generally favourable capital market conditions during the year continued to support the growth of our wealth management business. Economic growth weakened moderately in the latter part of the year mainly attributable to slowing U.S. demand, and a tightening of credit conditions as a result of the U.S. subprime mortgage market concerns.
     
 Wealth Management financial highlights   Table 25
                         
(C$ millions, except number of and percentage amounts)   2007     2006     2005  
 
Net interest income
   $ 427     $ 397     $ 374  
Non-interest income
                        
Fee-based revenue
     2,109       1,745       1,458  
Transactional and other revenue
     1,456       1,345       1,319  
Total revenue
   $ 3,992     $ 3,487     $ 3,151  
Non-interest expense
     2,902       2,613       2,440  
Provision for credit losses (PCL)
     1       1       2  
Net income before income taxes and non-controlling interest in subsidiaries
   $ 1,089     $ 872     $ 708  
Net income
   $ 762     $ 604     $ 502  
 
Key ratios
                        
Return on equity (1)
     32.4 %     27.8 %     24.5 %
Return on risk capital
     65.1 %     59.3 %     54.8 %
Pre-tax margin
     27.3 %     25.0 %     22.5 %
Selected average balance sheet information (2)
                        
Total assets
   $ 16,600     $ 15,100     $ 13,200  
Loans and acceptances
     4,600       4,400       4,100  
Deposits
     24,900       22,100       20,700  
Attributed capital (1)
     2,300       2,150       2,050  
Risk capital (1)
     1,150       1,050       900  
Other information
                        
Revenue per advisor (000s) (3)
   $ 784     $ 694     $ 687  
Assets under administration
     488,500       476,500       380,700  
Assets under management
     161,200       142,800       118,500  
Number of employees (full-time equivalent)
     10,382       9,667       8,791  
Number of advisors (3)
     3,118       3,001       2,934  
 
 
                        
 
 For the year ended                  
 
Impact of US$ translation on selected items 2007 vs. 2006                  
 
Reduced total revenue
   $ 61                  
Reduced non-interest expense
     49                  
Reduced net income
     9                  
 
Percentage change in average US$ equivalent of C$1.00 (4)
     4%                
 
(1)   Segment Return on equity, Average risk capital and Return on risk capital are key performance measures. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. For further discussion, refer to the Key performance and non-GAAP measures section.
 
(2)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(3)   Includes investment advisors and financial consultants of our Canadian and U.S. full-service brokerage businesses.
 
(4)   Average amounts are calculated using month-end spot rates for the year.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  61

 

 

(BAR CHART)
Financial performance
2007 vs. 2006
Net income for the year of $762 million increased $158 million, or 26%, from a year ago. The increase was largely due to strong earnings growth across all our business lines reflecting the ongoing successful execution of our growth initiatives and generally favourable market conditions. We recorded a $35 million ($28 million after-tax) foreign exchange translation gain on certain deposits in the current year related to the implementation of the new financial instruments accounting standards.
     Total revenue increased $505 million, or 14%, over the prior year, largely due to strong growth in fee-based client assets across all business lines, reflecting new sales, capital appreciation and the recruitment and retention of experienced advisors. A foreign exchange translation gain on certain deposits, the inclusion of our J.B. Hanauer acquisition, solid loan and deposit growth in our international wealth management business, and higher transactional volumes in our brokerage businesses reflecting generally favourable market conditions throughout the early part of the year also contributed to the increase. These factors were partially offset by the negative impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated revenue.
     Non-interest expense was up $289 million, or 11%, mainly as a result of higher variable compensation commensurate with higher commission-based revenue, higher staffing levels and other costs in support of business growth, including our acquisition of J.B. Hanauer. These factors were partially offset by the favourable impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated expenses.
2006 vs. 2005
Net income increased $102 million, or 20%, compared to 2005. The increase primarily reflected strong earnings growth across all our business lines and generally favourable market conditions. This increase was partially offset by higher variable compensation due to higher commission-based revenue, higher staffing costs and increased costs in support of business growth, including our acquisition of Abacus Financial Services Group Limited.
     Total revenue increased $336 million, or 11%, compared to 2005, largely due to strong growth in fee-based client assets reflecting new sales and capital appreciation, and the inclusion of our Abacus acquisition. These factors were partially offset by lower client transaction volumes in our brokerage businesses.
     Non-interest expense increased $173 million, or 7%, compared to 2005. The increase was primarily due to higher variable compensation commensurate with higher commission-based revenue, the inclusion of our Abacus acquisition and higher staffing levels.
2008 Outlook and priorities
The Canadian economic and business environment is expected to weaken slightly although business growth should continue to be supported by generally favourable capital market conditions. In the U.S., we anticipate that financial market volatility will persist into early 2008, but economic growth will reaccelerate in the latter part of 2008. Growth in other global economies is expected to ease moderately in 2008. This economic environment and the successful execution of our strategic priorities are anticipated to fuel our growth.
Key strategic priorities for 2008
•   Continue extending our lead in the Canadian wealth and asset management markets.
 
•   Pursue strong organic and acquisition growth in our U.S. wealth management businesses that serve individual clients and advisors.
 
•   Continue expanding our high net worth international wealth management business in select markets as well as through bolt-on acquisitions to complement our existing operations.
 
•   Focus on expanding our asset management business globally, initially through acquisitions with a focus on U.S. opportunities.
 
•   Work to continue attracting and retaining experienced advisors, private bankers and other client-facing professionals across all our businesses.
BUSINESS LINE REVIEW
Canadian Wealth Management
Canadian Wealth Management includes the market leader in full-service brokerage in Canada, with over 1,300 investment advisors, providing advisor-based comprehensive financial solutions. Additionally, we provide discretionary investment management and trust services to high net worth clients, offering a relationship approach for clients in need of sophisticated financial solutions. In these businesses, there are more than 28 investment counsellors and 125 trust professionals in locations across the country.
Financial performance
Revenue increased $170 million, or 13%, over the prior year, mostly due to strong growth in fee-based client assets reflecting higher net sales, capital appreciation and the recruitment and retention of experienced advisors. Higher transactional volumes in our brokerage business reflecting generally favourable market conditions also contributed to the increase.
     
Selected highlights   Table 26
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 1,460     $ 1,290     $ 1,164  
Other information
                        
Assets under administration
     183,000       168,600       146,400  
Assets under management
     22,200       17,500       12,700  
Total assets under fee-based programs
     83,300       70,200       56,500  
 
(BAR CHART)
Royal Bank of Canada: Annual Report 2007
62  Management’s Discussion and Analysis

 

 

 U.S. & International Wealth Management
U.S. & International Wealth Management consists of our retail brokerage business, which is one of the largest full-service firms in the U.S. with over 1,770 financial consultants. We also have a clearing and execution services business that serves small to mid-sized independent broker-dealers and institutions. Internationally, we provide customized banking, credit, investment and trust solutions to high net worth private clients through 2,300 employees across a network of 34 offices located in 20 countries around the world.
Financial performance
Revenue increased $256 million, or 15%, over the prior year. In U.S. dollars, revenue increased $293 million, or 19%, largely as a result of solid growth in fee-based client assets, higher transaction volumes in our U.S. brokerage business reflecting generally favourable market conditions throughout the early part of the year, and a foreign exchange translation gain on certain deposits. The inclusion of our J.B. Hanauer acquisition and solid loan and deposit growth in our international wealth management business also contributed to the increase.
     
 Selected highlights   Table 27
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 1,988     $ 1,732     $ 1,580  
Other information
                        
Total loans, guarantees and letters of credit (1), (2)
     5,500       4,500       3,900  
Total deposits (1), (2)
     17,900       15,100       13,900  
Assets under administration
     305,500       307,900       234,300  
Assets under management
     20,200       19,700       15,600  
Total assets under fee-based programs (3)
     26,600       26,400       20,700  
Other information (US$ millions)
                        
Total revenue
     1,826       1,533       1,305  
 
(1)   Represents amounts related to our international wealth management businesses.
 
(2)   Represents an average amount, which is calculated using methods intended to approximate the average of the daily balances for the period.
 
(3)   Represents amounts related to our U.S. wealth management businesses.
(BAR CHART)
 Global Asset Management
Global Asset Management is responsible for our proprietary asset management business in Canada and the U.S. In Canada, we provide a broad range of investment management services through mutual funds, pooled funds and separately managed portfolios. We distribute our investment solutions through a broad network of our bank branches, our discount and full-service brokers, independent advisors and direct-to-consumer. We are the largest single fund company and one of the largest money managers in Canada. In the U.S., we provide investment services to both retail and institutional clients through mutual funds, fee-based accounts and separately managed portfolios.
Financial performance
Revenue increased $79 million, or 17%, over the prior year, mainly reflecting strong growth in Canadian assets under management due to solid net long-term and money market mutual fund sales and capital appreciation.
     
 Selected highlights   Table 28
                         
(C$ millions)   2007     2006     2005  
 
Total revenue
   $ 544     $ 465     $ 407  
Other information
                        
Canadian net long-term mutual fund sales
     6,200       5,400       5,600  
Assets under management
     118,800       105,600       90,200  
 
(BAR CHART)
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  63

 

 

 U.S. & INTERNATIONAL BANKING
U.S. & International Banking comprises our banking businesses outside Canada, including our banking operations in the U.S. and Caribbean. In addition, this segment includes our 50% ownership in RBC Dexia IS.
     All of our businesses leverage the global resources of RBC, while drawing upon the knowledge and expertise of our local professionals to deliver customized solutions to our clients. We differentiate ourselves in each of our highly competitive marketplaces by tailoring solutions to meet our clients’ specific needs and building strong, long-lasting relationships by consistently delivering high-quality service.
Highlights
•   We continued to expand our banking footprint in key growth areas in the U.S. Southeast through targeted acquisitions and de novo branch openings. We acquired 39 AmSouth Bank branches (AmSouth branches) in Alabama and added 17 branches in Georgia when we acquired Flag Financial Corporation (Flag).
 
•   We realized a 12% (17% in Euros) growth in assets under administration with RBC Dexia IS, underpinned by both new and existing client growth.
 
•   We added a real estate lending team to our Caribbean operations, giving us the expertise to better serve clients across the region. In addition, we formed a small business unit to serve this growing client segment.
Economic and market review
The solid U.S. economic growth in the middle of the year, primarily supported by continued non-residential investment, strong export growth and consumer spending, slowed in the latter part of the year. The weakening economic conditions largely reflected the ongoing housing market correction, a tightening of credit conditions and increased funding costs arising from the U.S. subprime mortgage market concerns. This resulted in a general weakening in credit quality of residential real estate-related loans. Internationally, economic conditions in the Caribbean remained strong, although strong competition in the deposits market also tempered business growth. Solid economic conditions in Canada and the fast-growing asset management industry in Europe continued to support our global custody business growth.
     
 U.S. & International Banking financial highlights   Table 29
                         
(C$ millions, except percentage amounts)   2007     2006     2005  
 
Net interest income
   $ 1,031     $ 940     $ 923  
Non-interest income
     884       688       654  
Total revenue
   $ 1,915     $ 1,628     $ 1,577  
Non-interest expense
     1,481       1,216       1,136  
Provision for credit losses (PCL)
     109       25       49  
Net income before income taxes and non-controlling interest in subsidiaries
   $ 325     $ 387     $ 395  
Net income
   $ 242     $ 261     $ 256  
 
Key ratios
                        
Return on equity (1)
     6.9 %     10.6 %     10.8 %
Return on risk capital (1)
     11.7 %     16.1 %     16.4 %
Selected average balance sheet and other information (2)
                        
Total assets
   $ 39,700     $ 32,600     $ 25,900  
Loans and acceptances
     22,300       18,500       17,200  
Deposits
     34,200       28,700       21,200  
Attributed capital (1)
     3,350       2,400       2,350  
Risk capital (1)
     1,950       1,600       1,550  
Other information
                        
Assets under administration — RBC
     —       —       1,361,100  
Assets under administration — RBC Dexia IS (3)
     2,713,100       2,421,100       —  
Number of employees (full-time equivalent)
     6,001       5,034       6,880  
Credit information
                        
Gross impaired loans as a percentage of average net loans and acceptances
     1.91 %     1.01 %     .94 %
PCL as a percentage of average net loans and acceptances
     .49 %     .14 %     .28 %
 
 
                        
 
 For the year ended                  
Impact of US$ and Euro translation on selected items 2007 vs. 2006                
 
Reduced total revenue
   $ 8                  
Reduced non-interest expense
     6                  
Increased net income
     4                  
 
Percentage change in average US$ equivalent of C$1.00 (4)
     4 %                
Percentage change in average Euro equivalent of C$1.00 (4)
     (5 )%                
 
(1)   Segment Return on equity, Average risk capital and Return on risk capital are key performance measures. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. For further discussion, refer to the Key performance and non-GAAP measures section.
 
(2)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(3)   AUA — RBC Dexia IS represents the total AUA of the joint venture as at September 30, 2007. We have revised the 2006 amount to reflect the amount reported by RBC Dexia IS, as we had previously disclosed only the assets under custody amount related to our joint venture.
 
(4)   Average amounts are calculated using month-end spot rates for the year.
Royal Bank of Canada: Annual Report 2007
64  Management’s Discussion and Analysis

 

 

(BAR CHART)
Financial performance
2007 vs. 2006
Net income decreased $19 million, or 7%, from the prior year. The decrease was largely attributable to increased provision for credit losses, primarily reflecting higher impaired loans in our U.S. residential builder finance business. This was partially offset by strong business growth in RBC Dexia IS, as well as higher loan and deposit growth in the U.S. reflecting the inclusion of our acquisitions of Flag and the AmSouth branches, de novo branch openings and business expansion. Our results also reflected higher costs in support of business growth and a loss on the restructuring of our U.S. banking investment portfolio this year.
     Total revenue increased $287 million, or 18%, from the prior year. The increase was primarily attributable to RBC Dexia IS, reflecting strong market activity, an additional month of results and business growth. Banking revenue was also up largely due to loan and deposit growth, mainly reflecting the inclusion of Flag and the AmSouth branches, despite the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated revenue. These factors were partially offset by a loss on the restructuring of our U.S. banking investment portfolio this year.
     Non-interest expense was up $265 million, or 22%, over the prior year, largely reflecting higher costs in support of business growth. The increase primarily reflected higher processing and staff costs at RBC Dexia IS commensurate with business growth, the inclusion of our acquisitions of Flag and the AmSouth branches and the related integration costs, and U.S. de novo branch openings. Higher costs associated with an additional month of results relating to RBC Dexia IS, as well as an increase in sales and service personnel in our banking branch network also contributed to the increase.
     Provision for credit losses was up $84 million, largely due to higher impaired loans in our U.S. residential builder finance business, reflecting the downturn in the U.S. housing market in the latter part of the year. As at October 31, 2007, we had $2.8 billion in our U.S. residential builder finance loans outstanding.
2006 vs. 2005
Net income increased $5 million, or 2%, from 2005, largely reflecting solid growth and improved credit quality in Banking, partially offset by transaction expenses related to the transfer of Institutional & Investor Services to RBC Dexia IS.
     Total revenue increased $51 million, or 3%, from 2005, primarily reflecting strong revenue growth in RBC Dexia IS due to increased business volume. The increase was partially offset by lower Banking revenue due to the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated revenue. In U.S. dollars, Banking revenue increased $58 million, or 7%, reflecting solid loan and deposit growth and higher fee-based activities.
     Non-interest expense was up $80 million, or 7%, from 2005, primarily reflecting transaction expenses related to the transfer of IIS to RBC Dexia IS, as well as higher project-related spending and other costs in support of business growth.
     Provision for credit losses decreased $24 million, or 49%, compared to 2005, primarily reflecting strong credit quality in our U.S. banking loan portfolio in 2006.
2008 Outlook and priorities
We continue to see significant opportunities in the U.S. and Caribbean to expand our Banking business, through a combination of organic growth and strategic acquisitions. We anticipate that the current financial market volatility in the U.S. will persist into early 2008, as investors and lenders will remain cautious and risk averse amid the continued correction in the U.S. housing market. The anticipated improved U.S. economic conditions in the latter part of 2008, primarily underpinned by rising business investment, strong export growth and continued consumer spending against a backdrop of the abatement of current financial market volatility and the housing market correction, should support business and revenue growth. The projected solid economic growth in Canada and the Eurozone, as well as the increasing trend of outsourcing by fund managers in Canada, the Eurozone and Asia should continue to support RBC Dexia IS business growth.
Key strategic priorities for 2008
•   Continue implementing our long-term strategy to become the pre-eminent bank for businesses, business owners and professionals in the U.S. Southeast.
 
•   Efficiently integrate the pending acquisition of Alabama National BanCorporation for our U.S. banking operations, while retaining and growing our client base through continuous enhancement of our products and services and distribution network.
 
•   Build on our strong position in the Caribbean to create the leading bank in the region through the efficient integration of RBTT Financial Group, which we recently announced our intention to acquire, subject to closing conditions.
 
•   Pursue growth strategies with RBC Dexia IS that focus on strengthening the global client franchise, broadening its suite of products through innovation and expanding its presence in high-growth markets.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  65

 

 

BUSINESS LINE REVIEW
Banking
Banking consists of our banking operations in the U.S. and Caribbean. These businesses offer a broad range of banking products and services to personal and business clients in their respective markets, including residential construction finance services. Our U.S. banking business ranks 5th in deposit market share in North Carolina and among the top 15 in its U.S. Southeast banking footprint. It has a network of 350 branches and 395 ATMs. Caribbean banking ranks in the top three in deposit market share in most of its markets and has 44 branches and 78 ATMs.
Financial performance
Total revenue increased $86 million, or 8%, compared to the prior year, despite the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated revenue. In U.S. dollars, Banking revenue increased $114 million, or 12%, primarily driven by solid loan and deposit growth, reflecting the inclusion of Flag and the AmSouth branches, the 10 U.S. de novo branch openings since last year and business growth. These factors were partially offset by a loss on the restructuring of our U.S. banking investment portfolio. Net interest margin was down 16 bps, largely due to continued competitive pressure on deposit business, the reversal of accrued interest related to higher impaired loans this year, and a loss on the early redemption of trust preferred notes due to the impact of changes in our portfolio mix.
In U.S. dollars, average loans and acceptances, and deposits were up $3 billion (18%) and $2 billion (11%), respectively, from the prior year. The increase was primarily attributable to growth in loans and acceptances, and deposits in our U.S. banking operations of 18% and 12%, respectively, reflecting our acquisitions of Flag and the AmSouth branches, de novo branch openings and business growth. Growth in loans and acceptances, and deposits in our Caribbean banking operations of 14% and 8%, respectively, reflecting our continued focus on enhancing sales management and client satisfaction, also contributed to the increase.
      
Selected highlights   Table 30
                         
    2007     2006     2005  
 
Total revenue (C$ millions)
   $ 1,156     $ 1,070     $ 1,077  
Other information (US$ millions)
                        
Total revenue
   $ 1,059     $ 945     $ 887  
Net interest margin (1)
     3.56 %     3.73 %     3.70 %
Average loans and acceptances (2), (3)
   $ 17,800     $ 15,100     $ 14,200  
Average deposits (2), (3)
     17,700       15,900       15,500  
Number of:
                        
Branches
     394       325       315  
Automated teller machines
     473       385       371  
 
(1)   Net interest margin (NIM) is calculated as Net interest income divided by Average total earning assets. Average total earning assets are calculated using methods intended to approximate the average of the daily balances for the period.
 
(2)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(3)   Average loans and acceptances and Average deposits have been adjusted for 2005 for netting of a large Caribbean government account effective the fourth quarter of 2005, which reduced loan and deposit balances by a similar amount.
(BAR CHART)
RBC Dexia Investor Services
Our joint venture, RBC Dexia IS, offers an integrated suite of institutional investor products and services, including global custody, fund and pension administration, securities lending, shareholder services, analytics and other related services, to institutional investors worldwide. RBC Dexia IS was created on January 2, 2006, when we combined our Institutional & Investor Services (IIS) business with Luxembourg-based Dexia Funds Services in return for a 50% joint venture interest in RBC Dexia IS.
Financial performance
Total revenue was up $201 million, or 36%, compared to the prior year. The increase primarily reflected growth in our custodian and securities lending business on strong market activity, as well as organic growth from existing clients and the acquisition of new clients. An additional month of results reported in the year also contributed to the increase.
     Assets under administration were up 12% from a year ago. The increase was largely attributable to the acquisition of new clients, largely driven by an increase in sales as a result of our broadened product and service offerings, organic growth from existing customers and market appreciation.
 
Selected highlights   Table 31
                         
(C$ millions)   2007     2006     2005  
 
Total revenue (1)
  $ 759     $ 558     $ 500  
Other information
                        
Assets under administration
                        
RBC (2)
    —     —       1,361,100  
RBC Dexia IS (3)
    2,713,100       2,421,100     —  
 
(1)   Given the similarities between the IIS and RBC Dexia IS businesses, we have disclosed the revenue from our prior IIS business and our 50% proportionate ownership of RBC Dexia IS on the same line for comparative purposes. Revenue presented for 2006 represents two months of revenue from our IIS business earned between November 1, 2005, and the creation of RBC Dexia IS on January 2, 2006. The current period revenue also includes our proportionate share of RBC Dexia IS for the twelve months ended September 30, 2007, as RBC Dexia IS reports on a one month lag.
 
(2)   AUA — RBC represents total Assets under administration (AUA) of our IIS business. IIS AUA of $1,400 billion was contributed to RBC Dexia IS in exchange for our 50% ownership interest.
 
(3)   AUA — RBC Dexia IS represents the total AUA of the joint venture as at September 30, 2007. We have revised the 2006 amount to reflect the amount reported by RBC Dexia IS, as we had previously disclosed only the assets under custody amount related to our joint venture.
Royal Bank of Canada: Annual Report 2007
66  Management’s Discussion and Analysis

 

 

CAPITAL MARKETS
Capital Markets comprises our global wholesale banking business, which provides a wide range of corporate and investment banking, sales and trading, research and related products and services to corporations, public sector and institutional clients in North America and specialized products and services in select global markets. This segment consists of two main businesses, Global Markets and Global Investment Banking and Equity Markets. All other businesses are grouped under Other.
     We have an established reputation as a premier Canadian investment bank with top-tier market share in virtually all lines of wholesale business in Canada. We offer a full suite of products and service capabilities and have long-standing and deep relationships with our clients. We have a select but diversified set of global capabilities which includes fixed income, equity, foreign exchange, structured products, global infrastructure finance, and energy and mining.
     We remain committed to our businesses and will maintain our focus on being the undisputed leader in Canada, a top-tier leader in the U.S. mid-market, a global structurer and trader, and a leading global fixed income bank.
Highlights
•   We completed three acquisitions to access new clients and build on our capabilities: Carlin Financial Group, a U.S. broker-dealer known for its proprietary trade execution platform; Daniels & Associates, L.P., a U.S. merger and acquisition advisory firm; and Seasongood & Mayer, LLC, a U.S. public finance firm and municipal debt underwriter.
 
•   In 2007, we led or jointly led many significant debt and equity new issuance transactions totalling $184 billion.
 
•   We were involved in the top five merger and acquisitions transactions with Canadian involvement through the first three calendar quarters of 2007.
 
•   We were named Dealmaker of the Year in Canada four of the last five years (Financial Post) and the Best Investment Bank in Canada (Financial Post and Global Finance Magazine).
 
Capital Markets financial highlights   Table 32
                         
(C$ millions, except number of and percentage amounts)   2007     2006     2005  
 
Net interest income (1)
   $ 453     $ 131     $ 557  
Non-interest income
     3,936       4,005       3,005  
Total revenue (1)
   $ 4,389     $ 4,136     $ 3,562  
Non-interest expense
     2,769       2,603       2,890  
Provision for (recovery of) credit losses (PCL)
     (22 )     (115 )     (91 )
Net income before income taxes and non-controlling interest in subsidiaries (1)
   $ 1,642     $ 1,649     $ 762  
Net income
   $ 1,292     $ 1,355     $ 686  
 
Key ratios
                        
Return on equity (2)
     26.6 %     31.5 %     17.5 %
Return on risk capital (2)
     32.5 %     38.7 %     22.4 %
Selected average balance sheet information (3)
                        
Total assets
   $ 311,200     $ 260,600     $ 229,100  
Trading securities
     152,900       132,300       109,600  
Loans and acceptances
     29,000       22,100       17,600  
Deposits
     125,700       108,100       96,500  
Attributed capital (2)
     4,800       4,250       3,850  
Risk capital (2)
     3,900       3,450       3,050  
Other information
                        
Number of employees (full-time equivalent)
     3,364       2,936       2,762  
Credit information
                        
Gross impaired loans as a percentage of average net loans and acceptances
     .06 %     .28 %     .67 %
Specific PCL as a percentage of average net loans and acceptances
     (.08 )%     (.52 )%     (.52 )%
 
                         
    For the year ended                  
Impact of US$ and British pound translation on selected items (1)   2007 vs. 2006                  
 
Reduced total revenue (1)
   $ 70                  
Reduced non-interest expense
     15                  
Reduced net income
     30                  
 
Percentage change in average US$ equivalent of C$1.00 (4)
     4 %                
Percentage change in average British pound equivalent of C$1.00 (4)
     (5 )%                
 
(1)   Taxable equivalent basis. For further discussion, refer to the How we measure and report our business segments section.
 
(2)   Segment Return on equity, Average risk capital and Return on risk capital are key performance measures. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. For further discussion, refer to the Key performance and non-GAAP measures section.
 
(3)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(4)   Average amounts are calculated using month-end spot rates for the year.
(BAR CHART)
(BAR CHART)
(1)   Taxable equivalent basis. For further discussion, refer to the How we measure and report our business segments section.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  67

 

 

Economic and market review
Capital markets were generally favourable for the first part of 2007; however, a sudden and deep deterioration in the U.S. subprime residential mortgage-backed securities market in the latter part of 2007 had negative effects on the broader credit markets. This was characterized by significant credit spread widening, increased volatility in global equities, the credit rating agency downgrades of a broad group of collateralized debt obligations of asset-backed securities (CDOs of ABS) and U.S. RMBS instruments and a general lack of liquidity across a broad range of products including securities with strong credit ratings. The severe disruption in financial markets contributed to substantial writedowns and negatively impacted the effectiveness of hedging strategies for certain credit related products. Global central banks continued to provide liquidity to financial markets in an effort to minimize the impact of the market dislocation on the broader economy, including a 75 bps aggressive reduction in its overnight borrowing rate by the U.S. Federal Reserve during the fourth quarter of 2007. Lower levels of liquidity coupled with increased financial market volatility contributed to lower levels of origination activity compared to 2006. M&A activity remained strong for most of the year. The stronger Canadian dollar negatively impacted the translated value of our U.S. dollar- denominated earnings.
Financial performance
2007 vs. 2006
Net income decreased $63 million, or 5%, compared to a year ago largely due to writedowns recorded in the current year totalling $357 million on the valuation of U.S. subprime RMBS and CDOs of ABS in our Structured Credit business. The writedowns reflected the deterioration in the credit markets in the latter part of 2007 as a result of concerns over the U.S. subprime market, a general lack of liquidity and the recent credit rating agency downgrades of a broad group of CDOs of ABS and U.S. RMBS instruments. The negative impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated earnings also contributed to the decrease. These factors were partially offset by broad-based revenue growth in many other businesses. The writedowns of $357 million were offset by a $119 million compensation adjustment and $78 million income tax adjustment for a net impact of $160 million.
     Total revenue increased $253 million, or 6%. The increase was primarily due to increased equity derivatives and foreign exchange trading revenue, strong equity origination activity across all geographies and the inclusion of our recent acquisitions. Higher M&A activity, mainly in the U.S. gains associated with credit derivative contracts used to economically hedge our core lending portfolio reflecting the widening of credit spreads, and higher distributions on private equity investments also contributed to the increase. These factors were partially offset by lower trading revenue in our fixed income businesses reflecting the writedowns on the valuation of U.S. subprime RMBS and CDOs of ABS, the negative impact of the stronger Canadian dollar on the translated value of U.S. dollar-denominated revenue and lower U.S. debt origination results due in part to the tightening of credit markets in the latter part of 2007.
     Non-interest expense increased $166 million, or 6%, primarily reflecting increased costs in support of business growth, including higher staffing levels and the inclusion of our recent acquisitions. These factors were partially offset by lower variable compensation commensurate with weaker results and lower professional fees.
     Recovery of credit losses of $22 million in the current year compares to a recovery of credit losses of $115 million in the prior year, which included a $50 million reversal of the general allowance.
     Average assets were up $51 billion, or 19%, mainly due to increased trading securities primarily resulting from growth in certain equity trading strategies and in our fixed income trading businesses. Loans and acceptances increased $7 billion, or 31%, mainly related to strong investment banking activity and growth in our Infrastructure Finance business. Deposits increased $18 billion, or 16%, primarily due to increased funding requirements of our trading businesses. Credit quality remained strong as gross impaired loans decreased $43 million, or 72%, from a year ago.
2006 vs. 2005
Net income increased $669 million, or 98%, compared to 2005 primarily due to the prior year Enron litigation-related provision of $591 million ($326 million after-tax). Also contributing to the increase were record trading results, a lower effective income tax rate and near record M&A fees. These factors were partly offset by higher variable compensation on improved business performance and the negative impact of a stronger Canadian dollar on the translated value of our U.S. dollar- and British pound-denominated earnings.
     Total revenue increased $574 million, or 16%. The increase was primarily due to record trading results on improved market conditions and growth in certain equity trading strategies and stronger M&A activity. Higher distributions and gains from private equity investments, increased brokerage commissions and increased credit fees related to investment banking activity also contributed to the increase. These factors were partially offset by a decline in equity origination in Canada mainly reflecting uncertainty in equity markets outside the resource sector. Debt origination fees were also down, mainly in the U.S., due to the rising interest rate environment and further weakening of the U.S. dollar.
     Non-interest expense decreased $287 million, or 10%, largely reflecting the Enron litigation-related provision recorded in 2005 and the favourable reduction in the translated value of U.S. dollar- and British pound-denominated expenses due to the stronger Canadian dollar. Higher variable compensation on stronger business performance and higher spending in support of business growth initiatives partly offset the decrease.
     Recovery of credit losses of $115 million in 2006, including a $50 million reversal of the general allowance, compared to a recovery of credit losses of $91 million in 2005.
2008 Outlook and priorities
Credit market and liquidity concerns should abate as capital markets stabilize globally and gradually return to more normal levels of activity. The expected gradual improvement in market conditions should result in the recovery of underperforming businesses. In Canada, we will continue to build on our leadership position, while in the U.S. we remain focused on leveraging the strengths of recent acquisitions continuing to build our mid-market franchise and expanding into new sectors. Internationally, we will strategically expand our global capabilities, including strengthening our Infrastructure Finance business and expanding the distribution of structured and fixed income products into Asian markets. Our deal pipeline should remain fairly healthy and is expected to continue to grow; however, conversion remains a concern.
Key strategic priorities for 2008
•   Maintain our leadership position in Canada and deepen our penetration in the Canadian mid-market segment.
 
•   Continue to grow our Municipal Products business with the recently acquired platform of Seasongood & Mayer, expand our banking activities geographically and develop new product segments in the U.S.
 
•   Continue to expand the distribution of structured and fixed income products into Asian markets.
 
•   Continue to expand our infrastructure and project finance product offering from U.K. to other international and U.S. markets.
 
•   Continue to build our global energy capabilities, an area of strength for us.
Royal Bank of Canada: Annual Report 2007
68  Management’s Discussion and Analysis

 

 

BUSINESS LINE REVIEW
Global Markets
Global Markets is our centre for origination, trading and distribution of predominantly investment grade fixed income, foreign exchange and derivative products. It also conducts our proprietary trading operations, alternative asset and private equity businesses.
Financial performance
Global Markets revenue decreased $124 million, or 5%, from a year ago. Trading-related revenue was down $94 million, or 4%, primarily due to lower trading revenue in certain fixed income business as a result of writedowns totalling $357 million on the valuation of U.S. subprime RMBS and CDOs of ABS in our Structured Credit business. This was partially offset by higher equity derivatives and foreign exchange trading revenue due to business expansion and increased market volatility. Other revenue was down $30 million from a year ago largely due to lower private equity investment gains.
We led or jointly led 1,005 debt issues, up from 615 deals a year ago, with a total value of approximately $164 billion, and in Municipal Finance, we were involved in 779 issues with a total value of US$81 billion through October 2007.
 
Selected highlights   Table 33
                         
(C$ millions)   2007     2006     2005  
 
Total revenue (1)
   $ 2,455     $ 2,579     $ 2,256  
Other information
                        
Trading-related
     2,060       2,154       1,706  
Other (2)
     395       425       550  
 
(1)   Taxable equivalent basis. For further discussion, refer to the How we measure and report our business segments section.
 
(2)   Other includes debt origination, municipal products, gains/losses on private equity instruments, derivatives non-trading and securitization revenue.
(BAR CHART)
Global Investment Banking and Equity Markets
Global Investment Banking and Equity Markets brings together our investment banking and equity sales and trading capabilities to provide a complete suite of advisory and equity-related services to clients from origination, structuring and advising to distribution, sales and trading.
     Given the significant growth in our National Clients business, we transferred this business from Other to Global Investment Banking and Equity Markets in the second quarter of 2007.
Financial performance
Global Investment Banking and Equity Markets revenue increased $293 million, or 21%, compared to the prior year. Gross underwriting and advisory revenue was up $166 million, or 25%, largely reflecting strong equity origination activity across all geographies and improved M&A activity mainly in the U.S. Equity sales and trading revenue increased $92 million, or 33%, mainly due to the inclusion of our recent acquisitions, while Other revenue was up $35 million, or 8%, primarily reflecting higher private equity distributions and increased lending activity.
In 2007, we advised on 98 announced M&A deals with a total value of $190 billion. In 2007, we led or co-led 142 equity and equity-related new issues with a total market value of $20 billion, up from 82 in the prior year.
      
Selected highlights   Table 34
                         
(C$ millions)   2007     2006     2005  
 
Total revenue (1)
   $ 1,675     $ 1,382     $ 1,098  
Other information
                        
Gross underwriting and advisory fees
     831       665       598  
Equity sales and trading
     375       283       252  
Other (2)
     469       434       248  
 
(1)   Taxable equivalent basis. For further discussion, refer to the How we measure and report our business segments section.
 
(2)   Other includes increases in private equity distributions, growth in revenue associated with our core lending portfolio and syndicated finance and the gain on the exchange of our NYSE seats for NYX shares.
(BAR CHART)
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  69

 

 

Other
Other consists of our remaining businesses including our Global Credit business, which oversees the management of our core lending portfolios and manages our non-strategic lending portfolio. Global Credit also includes our Global Financial Institutions business which delivers innovative and creative solutions to global financial institutions including correspondent banking, treasury and cash management services. Research offers economic and securities research products to institutional clients in Canada and globally.
Financial performance
Revenue from Other was $259 million, an increase of $84 million, or 48%, over the prior year. The increase mainly reflected gains associated with credit derivative contracts used to economically hedge our core lending portfolio reflecting the widening of credit spreads and increased revenue in our Global Financial Institutions business due to higher deposit balances.
CORPORATE SUPPORT
Corporate Support segment activities include our global technology and operations group, corporate treasury, finance, human resources, risk management, internal audit and other global functions, the costs of which are largely allocated to the business segments.
     The reported results for the Corporate Support segment mainly reflect activities that are undertaken for the benefit of the organization, and which are not allocated to the business segments such as enterprise funding, securitization and the net charges associated with unattributed capital. The results also include consolidation adjustments including the elimination of the teb adjustments recorded in Capital Markets related to the gross-up of income from Canadian taxable corporate dividends to their taxable equivalent value. These adjustments are recorded in net interest income and offset in the provision for income taxes.
     Due to the nature of activities and consolidated adjustments reported in this segment, we believe that a year-over-year trend analysis is not relevant. The following identifies the material items affecting the reported results in each year.
     
Corporate Support financial highlights   Table 35
                         
(C$ millions)   2007     2006     2005  
 
Net interest income (1)
   $ (732 )   $ (488 )   $ (294 )
Non-interest income
     377       178       190  
Total revenue (1)
   $ (355 )   $ (310 )   $ (104 )
Non-interest expense
     36       36       61  
Recovery of credit losses
     (85 )     (86 )     (47 )
Business realignment charges
     —       —       39  
Net loss before income taxes and non-controlling interest in subsidiaries (1)
   $ (306 )   $ (260 )   $ (157 )
Net income (loss)
   $ 209     $ 111     $ (14 )
 
 
                        
Selected average balance sheet and other information (2)
                        
Total assets
   $ (6,500 )   $ (5,400 )   $ (4,000 )
Attributed capital (3)
     2,950       3,100       2,800  
Securitization
                        
Total securitizations sold and outstanding (4)
   $ 17,889     $ 15,836     $ 11,587  
New securitization activity in the year (5)
     4,264       6,142       3,821  
 
 
                        
Other information
                        
Number of employees (full-time equivalent)
     19,485       18,393       17,785  
 
(1)   Taxable equivalent basis. For further discussion, refer to the How we manage and report our business segments section. These amounts included the elimination of the adjustment related to the gross-up of income from Canadian corporate dividends of $332 million in 2007 recorded in Capital Markets (2006 — $213 million, 2005 — $109 million).
 
(2)   Average amounts are calculated using methods intended to approximate the average of the daily balances for the period.
 
(3)   For further discussion, refer to the Key performance and non-GAAP measures section.
 
(4)   Total securitizations sold and outstanding comprises of credit card loans and residential mortgages.
 
(5)   New securitization activity comprises residential mortgages and credit card loans securitized and sold in the year. For further details, refer to Note 5 of our Consolidated Financial Statements.
2007
Net income of $209 million for the year included income tax amounts largely related to enterprise funding activities that were not allocated to the business segments and favourable income tax settlements related to prior years. These factors were partially offset by the mark-to-market losses mainly related to the recognition of the ineffectiveness of hedged items and the related derivatives in hedge accounting relationships, a cumulative adjustment for losses resulting from the fair valuing of certain derivatives that did not qualify for hedge accounting and higher capital taxes that were not allocated to the business segments.
2006
Net income of $111 million for the year mainly reflected income tax amounts which were largely related to enterprise funding activities and the favourable resolution of income tax audits related to prior years not allocated to the business segments. Mark-to-market gains on derivatives related to certain economic hedges also contributed to net income in the year. These factors were partially offset by the timing of securitization activity and an amount accrued related to a leased space which we will not occupy and expect to sublease at a rate lower than our contracted rate.
2005
Net loss of $14 million largely reflected business realignment charges of $39 million, and mark-to-market losses on derivatives relating to certain economic hedges, which were partially offset by securitization activity and interest refunds relating to the resolution of disputed tax items for the 1993 to 1998 tax periods.
Royal Bank of Canada: Annual Report 2007
70  Management’s Discussion and Analysis

 

 

FINANCIAL CONDITION
     
Balance sheet   Table 36
                 
    As at October 31  
 
(C$ millions)   2007     2006  
 
Interest-bearing deposits with banks
   $ 11,881     $ 10,502  
Securities
     178,255       184,869  
Assets purchased under reverse repurchase agreements and securities borrowed
     64,313       59,378  
Loans
     239,429       209,939  
Other assets
     103,735       69,100  
Total assets
     600,346       536,780  
Deposits
     365,205       343,523  
Other liabilities
     201,284       160,575  
Non-controlling interest in subsidiaries
     1,483       1,775  
Shareholders’ equity
     24,439       22,123  
 
With the adoption of the new financial instruments accounting standards, certain financial instruments are now measured at fair value that were previously reported at cost or amortized cost. As a result, a greater portion of our Consolidated Balance Sheet is now measured at fair value, including certain derivative instruments. For further details, refer to the Critical accounting policies and estimates section as well as Notes 1 and 2 to our Consolidated Financial Statements.
2007 vs. 2006
Total assets were up $64 billion, or 12%, from a year ago, driven by growth across most asset categories. The increase was largely attributable to solid loan growth, including Canadian residential mortgages and personal and business loans, amid generally favourable domestic market conditions. Higher balances related to derivative-related amounts, primarily reflecting changes in market conditions, also contributed to the increase.
     Interest-bearing deposits with banks increased $1 billion, or 13%, from the prior year, largely reflecting a shift in our portfolio mix to higher-yielding assets.
     Securities were down $7 billion, or 4%, from a year ago, primarily due to a strategic reduction in our positions taking into account recent financial market volatility, and the impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated securities.
     Assets purchased under reverse repurchase agreements and securities borrowed increased $5 billion, or 8%, from a year ago. This growth primarily reflected higher balances in support of our equity and fixed income trading strategies.
     Loans increased $29 billion, or 14%, from a year ago, reflecting increases across all categories. The largest growth was attributable to Canadian residential mortgages, which increased $13 billion, or 14% (despite the offsetting effect of $13 billion of securitizations over the past 12 months) and personal loans, largely driven by demand for home equity lending amid continued strong Canadian housing market activities, relatively low interest rates in a historical context and strong labour market conditions. Solid growth in our wholesale loans of $11 billion, or 19%, mainly reflecting continued growth in corporate lending also contributed to the increase.
     Other assets were up $35 billion, or 50%. The growth was mainly attributable to an increase in derivative-related amounts primarily in foreign exchange and interest rate contracts, reflecting increased volatility, strong shifts in exchange rates and interest rates, as well as higher client and trading activity. These factors were partially offset by the impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated derivative-related assets.
     Deposits increased $22 billion, or 6%, from a year ago. The growth was largely due to increased business and government deposits mainly reflecting higher balances in support of business activities, increased balances at RBC Dexia IS, and domestic business growth. Higher personal deposits in part driven by the success of our recently launched high-interest online savings account also contributed to the increase. These factors were partially offset by a reduction in interest-bearing deposits with banks in part reflecting our lower funding requirements compared to a year ago.
     Other liabilities rose $41 billion, or 25%, from last year. The increase was mainly due to derivative-related amounts, primarily reflecting the same factors noted above in derivative-related assets. Increased securities sold short, mainly reflecting business growth and higher balance in support of our fixed income trading strategies, also contributed to the increase.
     Shareholders’ equity increased $2 billion, or 10%, over the prior year. The growth largely reflected strong earnings growth, net of dividends, and a $1 billion net issuance of preferred shares since last year.
CAPITAL MANAGEMENT
Capital management framework
We actively manage our capital to balance the desire to maintain strong capital ratios and high ratings with the objective of providing strong returns to our shareholders. In striving to achieve this balance, we consider the requirements of regulators, rating agencies, depositors and shareholders, as well as our future business plans, peer comparisons and our position relative to internal targets for capital ratios. Additional considerations include the costs and terms of current and potential capital issuances, and projected capital requirements.
     Our capital management framework provides the policies and processes for defining, measuring, raising and investing all forms of capital in a co-ordinated and consistent manner. We manage and monitor our capital from several perspectives, including:
(i)   Regulatory capital: capital required for regulatory compliance defined in accordance with the Office of the Superintendent of
Financial Institutions Canada (OSFI) criteria;
 
(ii)   Economic Capital: an internal assessment of the amount of equity capital required to underpin our risks; and
 
(iii)   Subsidiary capital: the amount of regulatory capital invested in subsidiaries.
This co-ordinated approach to capital management serves an important business function. Our goal is to optimize our capital usage and structure and provide efficient support for our business segments and clients and better returns for our shareholders, while protecting our depositors and senior creditors.
Governance
The Board of Directors is responsible for the annual review and approval of our capital plan, in conjunction with our operating plan. The Audit Committee is responsible for the governance of capital management, which includes the approval of capital management policies,
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  71

 

 

the regular review of our capital position and liquidity, funding and capital management processes, and the ongoing review of internal control over financial reporting. In addition, the OSFI meets with our Audit Committee and the Conduct Review and Risk Policy Committee (CR&RPC) to discuss policies and procedures regarding capital management.
     The Asset & Liability Committee and the Group Executive share management oversight responsibility for capital management and receive regular reports detailing compliance with the established limits and guidelines. Corporate Treasury and Group Risk Management (GRM) are responsible for the design and implementation of policies for regulatory, economic and subsidiary capital.
Risk-adjusted assets (RAA)
Under the current Basel I framework, the calculation of RAA is determined by the OSFI-prescribed rules relating to on-balance sheet and off-balance sheet exposures and includes an amount for the market risk exposure associated with our trading portfolios.
     During the year, RAA increased by $23.9 billion, with strong growth across most categories including loans, mortgages, and off-balance sheet derivative instruments. However, growth in nominal assets was partially offset by the impact of a stronger Canadian dollar on the translated value of our foreign currency-denominated assets.
     
Risk-adjusted assets (1)   Table 37
                                 
                    Risk-adjusted balance  
            Weighted              
    Balance     average of              
(C$ millions, except percentage amounts)   sheet amount     risk weights (2)     2007     2006  
 
Balance sheet assets
                                
Cash and deposits with banks
   $ 16,107       18 %   $ 2,852     $ 2,322  
Securities
                                
Issued or guaranteed by Canadian or other OECD (3) governments
     16,858       —       52       42  
Other
     161,591       6 %     9,495       7,811  
Residential mortgages (4)
                                
Insured
     27,994       1 %     355       363  
Conventional
     81,713       40 %     32,885       27,921  
Other loans and acceptances (4)
                                
Issued or guaranteed by Canadian or other OECD (3) governments
     32,577       17 %     5,651       3,848  
Other
     171,422       69 %     118,723       107,336  
Other assets
     92,100       11 %     10,487       10,609  
             
 
   $ 600,362             $ 180,500     $ 160,252  
             
                                 
    Credit                          
    equivalent                          
    amount (5)                          
                         
Off-balance sheet financial instruments
                                
Credit instruments
                                
Guarantees and standby letters of credit
   $ 19,758       60 %   $ 11,807     $ 14,092  
Documentary and commercial letters of credit
     100       78 %     78       65  
Securities lending (6)
     36,187       3 %     962       3,022  
Commitments to extend credit
     21,954       85 %     18,752       16,666  
Liquidity facilities
     4,826       98 %     4,746       4,413  
Note issuances and revolving underwriting facilities
     —       —       —       4  
             
 
   $ 82,825             $ 36,345     $ 38,262  
             
Derivatives (7)
     57,973       25 %     14,457       10,432  
             
Total off-balance sheet financial instruments
   $ 140,798             $ 50,802     $ 48,694  
             
Total specific and general market risk
                     16,333       14,763  
             
Total risk-adjusted assets
                   $ 247,635     $ 223,709  
             
(1)   Calculated using guidelines issued by the OSFI.
 
(2)   Represents the weighted average of counterparty risk weights within a particular category.
 
(3)   OECD stands for Organisation for Economic Co-operation and Development.
 
(4)   Amounts are shown net of allowance for loan losses.
 
(5)   The amount of credit exposure attributable to an off-balance sheet financial instrument, derived from the notional value of the exposure.
 
(6)   In 2007, we implemented a new trading credit risk system in our London office that enables clearer identification of these balances, resulting in a lower risk-adjusted balance.
 
(7)   Excludes non-trading credit derivatives given guarantee treatment for credit risk capital purposes.
Regulatory capital and capital ratios
Capital levels for Canadian banks are regulated pursuant to guidelines issued by the OSFI, based on standards issued by the Bank for International Settlements. Regulatory capital is allocated to two tiers: Tier 1 and Tier 2. Tier 1 capital comprises the more permanent components of capital and consists primarily of common shareholders’ equity, non-cumulative preferred shares, the majority of which do not have conversion features into common shares, and the eligible amount of innovative capital instruments. In addition, goodwill is deducted from Tier 1 capital.
     Tier 2 capital consists mainly of subordinated debentures, trust subordinated notes, the eligible amount of innovative capital instruments that could not be included in Tier 1 capital, and an eligible portion of the total general allowance for credit losses. Total capital is defined as the total of Tier 1 and Tier 2 capital less deductions as prescribed by the OSFI. For further details on the terms and conditions of our non-cumulative preferred shares and innovative capital instruments, refer to Notes 17 and 18 of our Consolidated Financial Statements.
     Regulatory capital ratios are calculated by dividing Tier 1 and Total capital by RAA. The OSFI formally establishes risk-based capital targets for deposit-taking institutions in Canada. These targets are currently a Tier 1 capital ratio of 7% and a Total capital ratio of 10%. In addition to the Tier 1 and Total capital ratios, Canadian banks are required to ensure that their assets-to-capital multiple, which is calculated by dividing gross adjusted assets by Total capital, does not exceed a maximum level prescribed by the OSFI.
     The components of regulatory capital and our regulatory capital ratios are shown in the following table.
Royal Bank of Canada: Annual Report 2007
72  Management’s Discussion and Analysis

 

 

Regulatory capital and capital ratios (1)   Table 38
                 
(C$ millions, except percentage amounts)   2007     2006  
 
Tier 1 capital
                
Common equity (2)
   $ 22,272     $ 21,065  
Non-cumulative preferred shares
     2,344       1,345  
Trust capital securities
     3,494       3,222  
Other non-controlling interest in subsidiaries
     25       28  
Goodwill
     (4,752 )     (4,182 )
 
 
     23,383       21,478  
 
Tier 2 capital
                
Permanent subordinated debentures (3)
     779       839  
Non-permanent subordinated debentures (3)
     5,473       6,313  
General allowances
     1,221       1,223  
Trust capital securities (excess over 15% Tier 1)
     —       249  
Trust subordinated notes
     1,027       —  
Accumulated net unrealized gain on available-for-sale equity securities (4)
     105       —  
 
 
     8,605       8,624  
 
Other deductions from capital
                
Investment in insurance subsidiaries
     (2,912 )     (2,795 )
Other
     (505 )     (643 )
 
Total capital
   $ 28,571     $ 26,664  
 
Capital ratios
                
Tier 1 capital to risk-adjusted assets
     9.4 %     9.6 %
Total capital to risk-adjusted assets
     11.5 %     11.9 %
Assets-to-capital multiple
     19.9X     19.7X
 
 
(1)   As defined in the guidelines issued by the OSFI.
 
(2)   This amount is Shareholders’ equity less preferred shares of $2,050 million and other items not included in regulatory capital of $117 million.
 
(3)   Subordinated debentures that are within five years of maturity are subject to straight-line amortization to zero during their remaining term and, accordingly, are included above at their amortized value.
 
(4)   As prescribed by the OSFI, certain components of Accumulated other comprehensive income (AOCI) are included in the determination of regulatory capital. Accumulated net foreign currency translation adjustments are included in Tier 1 capital in common equity. Net unrealized fair value losses on available-for-sale (AFS) equities are deducted in the determination of Tier 1 capital while net unrealized fair value gains on AFS equities are included in Tier 2 capital.
(BAR CHART)
As at October 31, 2007, the Tier 1 capital ratio was 9.4% and the Total capital ratio was 11.5%.
     The Tier 1 capital ratio was down 20 bps from a year ago. The decrease was largely due to business growth, including acquisitions, which resulted in an increase in RAA and a higher goodwill deduction from capital. The impact of our common share repurchases under our normal course issuer bid also contributed to the decrease. These factors were partially offset by strong generation of capital from earnings and the issuance of preferred shares.
     The Total capital ratio was down 40 bps from a year ago due to growth in RAA and the redemption of subordinated debentures. These factors were partially offset by the issuance of trust subordinated notes.
     As at October 31, 2007, our assets-to-capital multiple was 19.9 compared to 19.7 a year ago. Our assets-to-capital multiple remains below the maximum of 23 that is allowed by the OSFI.

Selected capital management activity   Table 39
                 
(C$ millions)   2007     2006  
 
Dividends
                
Common
   $ 2,321     $ 1,847  
Preferred
     88       60  
Common shares issued (1)
     152       115  
Repurchase of common shares — normal course issuer bid (2)
     (646 )     (844 )
Preferred shares issued
     1,150       600  
Preferred shares redeemed
     (150 )     (250 )
Subordinated debentures issued
     87       —  
Repurchase and redemption of debentures (3)
     (985 )     (955 )
Issuance of Trust subordinated notes (4)
     1,000       —  
 
(1)   Represents cash received for stock options exercised during the year.
 
(2)   For further details, refer to Note 18 to our Consolidated Financial Statements.
 
(3)   For further details, refer to Note 16 to our Consolidated Financial Statements.
 
(4)   For further details, refer to Note 17 to our Consolidated Financial Statements.
     
    Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 73

 

 

In 2007, we undertook several initiatives to support the effective management of our capital.
Tier 1
In 2007, we repurchased 11.8 million common shares for $646 million under our NCIB that expired on October 31, 2007. Effective November 1, 2007, we renewed our NCIB to repurchase up to 20 million common shares, or 1.6%, of our outstanding common shares as at October 31, 2007. This NCIB will expire on October 31, 2008.
     On April 26, 2007, we issued $250 million of Non-cumulative First Preferred Shares Series AG at $25 per share.
     On March 14, 2007, we issued $200 million of Non-cumulative First Preferred Shares Series AF at $25 per share.
     On January 19, 2007, we issued $250 million of Non-cumulative First Preferred Shares Series AE at $25 per share.
     On December 13, 2006, we issued $250 million of Non-cumulative First Preferred Shares Series AD at $25 per share.
     On November 24, 2006, we redeemed all of the issued and outstanding $150 million Non-cumulative First Preferred Shares Series O.
     On November 1, 2006, we issued $200 million of Non-cumulative First Preferred Shares Series AC at $25 per share.
Tier 2
During the year, we purchased US$24 million of our outstanding US$300 million floating rate debentures maturing in 2085.
     On June 26, 2007, we issued JP¥10 billion (C$87 million) Japanese Yen-denominated subordinated debentures.
     On June 4, 2007, we redeemed all of our outstanding $500 million subordinated debentures due June 4, 2012, at par value plus accrued interest.
     On April 30, 2007, we issued $1 billion of subordinated debentures through RBC Subordinated Notes Trust, a closed-end trust wholly owned by us.
     On November 8, 2006, we redeemed all of our outstanding US$400 million floating-rate subordinated debentures due November 8, 2011, for 100% of their principal amount plus accrued interest to the redemption date.
Dividends
Our common share dividend policy reflects our earnings outlook, desired payout ratio and the need to maintain adequate levels of capital to fund business opportunities. The targeted common share dividend payout ratio for 2007 was 40% to 50%. In 2007, the dividend payout ratio was 43%, up from 40% in 2006. Common share dividends paid during the year were $2.3 billion, up 26% from a year ago.

Share data and dividends   Table 40
                                                                         
    2007     2006     2005  
 
(C$ millions, except number of shares   Number of             Dividends     Number of             Dividends     Number of             Dividends  
and per share amounts)   shares (000s)     Amount     per share     shares (000s)     Amount     per share     shares (000s)     Amount     per share  
 
First Preferred (1)
                                                                        
Non-cumulative Series N
     12,000     $ 300     $ 1.18       12,000     $ 300     $ 1.18       12,000     $ 300     $ 1.18  
Non-cumulative Series O
     —       —       —       6,000       150       1.38       6,000       150       1.38  
Non-cumulative Series S
     —       —       —       —       —       1.33       10,000       250       1.53  
Non-cumulative Series W
     12,000       300       1.23       12,000       300       1.23       12,000       300       .99  
Non-cumulative Series AA
     12,000       300       1.11       12,000       300       .71       —       —       —  
Non-cumulative Series AB
     12,000       300       1.18       12,000       300       .41       —       —       —  
Non-cumulative Series AC
     8,000       200       1.22       —       —       —       —       —       —  
Non-cumulative Series AD
     10,000       250       1.06       —       —       —       —       —       —  
Non-cumulative Series AE
     10,000       250       .95       —       —       —       —       —       —  
Non-cumulative Series AF
     8,000       200       .77       —       —       —       —       —       —  
Non-cumulative Series AG
     10,000       250       .65       —       —       —       —       —       —  
 
Total First Preferred
           $ 2,350                     $ 1,350                     $ 1,000          
 
Common shares outstanding
     1,276,260     $ 7,300     $ 1.82       1,280,890     $ 7,196     $ 1.44       1,293,502     $ 7,170     $ 1.18  
Treasury shares — preferred
     (249 )     (6 )             (94 )     (2 )             (91 )     (2 )        
Treasury shares — common
     (2,444 )     (101 )             (5,486 )     (180 )             (7,053 )     (216 )        
Stock options
                                                                        
Outstanding
     26,623                       32,243                       36,481                  
Exercisable
     21,924                       26,918                       28,863                  
 
(1)   As at October 31, 2007, the aggregate number of common shares issuable on the conversion of the First Preferred Shares Series N was approximately 5,743,000. As at October 31, 2007, the First Preferred Shares Series W was not yet convertible. The other preferred shares do not have conversion options.
As at November 23, 2007, the number of outstanding common shares and stock options were 1,276,292,000 and 26,591,000, respectively. As at November 23, 2007, the number of Treasury shares — preferred and Treasury shares — common were 263,000 and 2,775,000, respectively. For further information about our share capital, refer to Notes 18 and 21 to our Consolidated Financial Statements.
     
Royal Bank of Canada: Annual Report 2007
74 Management’s Discussion and Analysis 		 

 

 

Hedging foreign currency-denominated operations
Increasing amounts of U.S. dollar-denominated assets and deductions from regulatory capital prompted our development of a policy for hedging our foreign exchange exposure with respect to our foreign operations. The objectives of our hedging policy are: (i) stabilization of our consolidated regulatory capital ratios from currency fluctuations, and (ii) mitigation of potential earnings volatility that might result if we dispose of these investments in foreign operations. When the Canadian dollar strengthens/weakens against other currencies, the losses/gains on net foreign investments reduce/increase our capital, as well as our RAA and goodwill of the foreign currency-denominated operations. Selecting an appropriate level for hedging of our investment in foreign operations ensures that our regulatory capital ratios are not materially impacted by currency fluctuations due to the offsetting impact of the proportionate movements in the assets and capital.
     Hedging our operations denominated in foreign currencies promotes orderly and efficient capital management. It facilitates compliance with regulatory requirements on an ongoing basis and enables us to maintain greater control over key capital ratios, thereby reducing the need for capital transactions in response to currency fluctuations.
Economic Capital
Economic Capital is our own quantification of risks associated with business activities. Economic Capital is defined as the capital required to remain solvent and in business even under extreme market conditions, given our desire to maintain a debt rating of at least AA. Economic Capital is attributed to each business segment in proportion to management’s assessment of the risks. It allows for comparable performance measurements among our business segments through Return on Equity (ROE) and Return on Risk Capital (RORC), which are described in detail in the Key performance and non-GAAP measures section. Accordingly, Economic Capital aids senior management in resource allocation and serves as a reference point for the assessment of our aggregate risk appetite in relation to our financial position, recognizing that factors outside the scope of Economic Capital must also be taken into consideration.
     Economic Capital is also used to assess the adequacy of our capital base. Our policy is to maintain a level of common equity, and other instruments with equity-like permanence and loss absorption features that exceed Economic Capital with a comfortable cushion.
     Economic Capital is calculated and attributed on a wider array of risks than is regulatory capital, which is primarily limited to credit, market (trading) and, under Basel II, operational risk. Economic Capital also includes goodwill and intangibles. The identified risks (described below) for which we calculate Economic Capital are credit, market (trading and non-trading), operational, business, fixed asset, and insurance. Additionally, Economic Capital allows for diversification benefits across risks and business segments.
•   Credit risk is the risk of loss associated with a counterparty’s inability or unwillingness to fulfill its payment obligations.
 
•   Market risk is the risk of loss that may arise from changes in market factors such as interest rates, foreign exchange rates, equity or commodity prices, or the volatility of these factors, in both banking and trading books. Market risk can be exacerbated by thinly traded or illiquid markets.
 
•   Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
 
•   Business risk is the risk of loss due to variances in volumes, prices and costs caused by competitive forces, regulatory changes, reputation and strategic risks.
 
•   Fixed asset risk is defined as the risk that the value of fixed assets will be less than their book value at a future date.
 
•   Insurance risk is the risk of loss that may occur when assumptions made in insurance product design and pricing activities differ from actual experience.
For further discussion of credit, market, operational and insurance risk, refer to the Risk management section.
     The calculation and attribution of Economic Capital involves a number of assumptions and judgments. The methodologies are continually monitored to ensure that the Economic Capital framework is comprehensive and consistent. Economic Capital measurement models and techniques are developed by GRM and are subject to independent assessment for appropriateness and reliability. The models are continually benchmarked to leading industry practices via participation in surveys, reviews of methodologies and ongoing interaction with external risk-management industry professionals. The models and input parameters are subject to independent vetting and validation, as per internal model risk policies.

Economic Capital   Table 41
                 
(C$ millions average balances)   2007     2006  
 
Credit risk
   $ 6,850     $ 5,800  
Market risk (trading and non-trading)
     2,700       2,500  
Operational risk
     2,750       2,450  
Business and fixed asset risk
     2,000       1,800  
Insurance risk
     150       200  
 
Risk capital
   $ 14,450     $ 12,750  
Goodwill and intangibles
     5,550       4,650  
 
Economic Capital
   $ 20,000     $ 17,400  
Unattributed capital
     2,000       2,500  
Common equity
   $ 22,000     $ 19,900  
 
Economic Capital increased $2.6 billion from a year ago largely due to increases in Credit risk capital, Goodwill and intangibles and Operational risk capital. The increases in Credit risk and Operational risk capital were primarily due to business growth including the impact of our acquisitions of Flag, the AmSouth branches and Carlin. Goodwill and intangibles increased primarily as a result of these acquisitions, which were partially offset by the favourable impact of a stronger Canadian dollar on the translated value of foreign currency-denominated assets.
     We remain well capitalized with current levels of qualified equity exceeding the Economic Capital required to underpin all of our risks.
     
    Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 75

 

 

Subsidiary capital
Management of consolidated capital has become a strategic objective for us as the amount of capital deployed in subsidiaries to build their businesses has grown in order to maximize profits and returns to our shareholders. Accordingly, regulatory bodies have focused on ensuring that for all internationally active banks, capital recognized in regulatory capital measurements is accessible by the parent entity. At the same time, subsidiaries should be sufficiently capitalized on a stand-alone basis and in compliance with local regulatory requirements at all times. In addition to minimum capital requirements, these local regulations may include restrictions on the transfer of assets in the form of cash, dividends, loans or advances. For further details, refer to Note 18 to our Consolidated Financial Statements. To balance these regulatory requirements and facilitate the co-ordinated generation and allocation of capital across the enterprise, we have put in place a comprehensive subsidiary capital management framework. This framework sets guidelines for defining capital investments in our subsidiaries and establishes an overall limit for total investment in those subsidiaries.
     While each of our subsidiaries has individual responsibility for calculating, monitoring and maintaining capital adequacy in compliance with the laws and regulations of its local jurisdiction, Corporate Treasury is mandated to provide centralized oversight and consolidated capital base management across various entities.
Other considerations affecting capital
Transition to Basel II
Beginning in the first quarter of 2008, as a result of the OSFI’s adoption of new guidelines based on “International Convergence of Capital Measurement and Capital Standards: A Revised Framework — Comprehensive Version (June 2006),” known as Basel II, Canadian banks will be required to calculate and report their regulatory capital ratios under new measurement standards. We intend to adopt the Advanced Internal Ratings Based (AIRB) Approach for credit risk and, initially, the Standardized Approach for operational risk. There will be no changes in the treatment of market risk. For details on our Basel II risk approaches, refer to the Risk management section.
     As part of the Basel II process, Canadian banks must demonstrate to the OSFI that they have met the AIRB requirements and that their capital reporting is accurate and of high quality. The OSFI has been engaged in extensive AIRB approval reviews throughout 2007. Our final application package, for adoption of the AIRB Approach for most material portfolios, was submitted to the OSFI on October 31, 2007 and the formal approval decision is expected by December 31, 2007. Once we achieve full compliance with the AIRB requirements and the OSFI has agreed, we may proceed to reflect capital below Basel I levels, subject to a two-year transitional floor requirement where our capital must reflect 90% and 80% of our Basel I capital charges. As required by the OSFI since November 1, 2006, we have been calculating capital requirements in parallel under both the Basel I and Basel II rules.
     Also, the OSFI has made some allowances for staged implementation. In particular, the OSFI has approved a waiver for RBC Centura Bank to use the Standardized Approach for credit risk until 2010. We have also been granted an extension (applicable to non-North American portfolios) for RBC Dexia IS, which plans to implement the AIRB approach by June 2008. Additionally, the OSFI has approved an exemption for our Caribbean banking operations to report under the Standardized Approach as long as that portfolio remains non-material (defined as 1% or less of total balance sheet and credit equivalent amounts).
     Notwithstanding that our risk and capital management processes were already substantially consistent with the principles embodied in Basel II, we have introduced new policies and enhanced practices, as appropriate, to facilitate transition to Basel II. These include meeting requisite standards for:
•   risk rating system design and operation
•   risk quantification, validation, and use of rating systems and internal ratings
•   corporate governance and oversight
•   implementation of a robust internal capital adequacy assessment process (ICAAP).
Our approach to capital adequacy is a co-ordinated effort involving functional units such as GRM, Corporate Treasury, and Finance. Currently, GRM works in partnership with our businesses to identify, measure, mitigate and monitor all forms of risk, as described in the Risk management section. Capital adequacy is assessed and determined with consideration of the full range of risk controls and capital management tools available to us. We view capital adequacy as a dynamic process that considers multiple variables, including earnings, asset growth and capital transactions, within regulatory and financial market constraints in order to meet strategic goals.
     Our initial ICAAP was presented to the Audit Committee in October 2007. This ICAAP incorporates senior management oversight, comprehensive risk-based stress testing of regulatory capital requirements and our own assessment of risk based on Economic Capital, which is expected to play a greater role in capital adequacy assessments under Basel II.
     Our ICAAP demonstrates that we are well capitalized, having enough capital to meet management’s assessment of required capital under both normal market conditions and a range of severe but plausible stress testing scenarios. It serves as an important tool in the establishment of our internal capital ratios target within the broader context of our capital management framework, and will be subject to annual review and ongoing development.
     In addition to our ICAAP, several of our subsidiaries are required to submit entity level ICAAPs to local regulators. While these assessments are the responsibility of the respective subsidiaries, Corporate Treasury liaises with subsidiaries to ensure enterprise-wide consistency.
     Our implementation of Basel II will produce capital requirements that may differ from those calculated under the current Basel I framework. For the most part, this reflects a shift in calculation methodology from application of prescribed risk weights to processes that are more closely aligned with our internal risk management practices. Also, Basel II incorporates a specific charge for operational risk that is not currently required under Basel I. As Basel II will be applied on a prospective basis, comparability to historical data and capital ratios reported under Basel I may be difficult.
     Disclosure requirements under Basel II will begin with our first quarter 2008 financial disclosure, and will continue to evolve over 2008, with all quantitative and qualitative requirements being met with the release of our 2008 annual report.
Accounting considerations
In addition to the regulatory environment, we closely monitor changes in accounting rules and their potential impact on our capitalization levels. With the recent adoption of the new financial instruments accounting standards under Canadian GAAP, differences exist between the measurement of capital as disclosed in the financial statements and that used for regulatory capital purposes. For example, under Canadian GAAP, available-for-sale (AFS) debt securities are recognized at fair value, with unrealized gains and losses reported in Accumulated other comprehensive income (AOCI). In contrast, for regulatory capital purposes, these securities are measured at amortized cost, and consequently, no unrealized gains or losses are reflected in regulatory capital. Additionally, the unrealized gains and losses on derivatives designated as cash flow hedges and reported in AOCI are excluded from regulatory capital.
     Capital treatment for equity investments in other entities is determined by a combination of accounting and legal guidelines based on the size or nature of the investment. Three broad approaches apply as follows:
•   Consolidation: entities in which we have a controlling interest must be fully consolidated on our consolidated balance sheet. Joint ventures are consolidated on a pro rata basis. Consolidated holdings are capitalized directly by asset class and are not treated as equity investments for regulatory capital calculation purposes.
     
Royal Bank of Canada: Annual Report 2007
76 Management’s Discussion and Analysis 		 

 

 

•   Deduction: certain holdings are deducted in full from our regulatory capital. These include all “substantial” investments (as defined by the Bank Act), as well as all investments in insurance subsidiaries.
 
•   Risk weighting: unconsolidated equity investments that are not deducted from capital are risk weighted at a prescribed rate for determination of capital charges.
While Basel II retains the same criteria for determination of capital treatment of equities, the prescribed risk weightings are generally higher than under Basel I.
OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of business, we engage in a variety of financial transactions that, under GAAP, are not recorded on our balance sheet. Off-balance sheet transactions are generally undertaken for risk management, capital management and/or funding management purposes for our benefit and the benefit of our clients. These transactions include transactions with special purpose entities and issuance of guarantees. These transactions give rise to, among other risks, varying degrees of market, credit, liquidity and funding risk, which are discussed in the Risk management section.
Derivatives
On November 1, 2006, we adopted three new accounting standards that were issued by the CICA related to financial instruments. These standards and the impact on our financial position and results of operations are discussed in the Impact of the new financial instruments accounting standards section and in Note 1 to our Consolidated Financial Statements. With the adoption of these standards, all derivatives including derivatives that qualified for hedge accounting are now recognized on the Consolidated Balance Sheets at fair value. Prior to November 1, 2006, derivatives that qualified for hedge accounting were not carried at fair value on our Consolidated Balance Sheets. Refer to Note 7 to our Consolidated Financial Statements for detailed information on our derivatives products.
Special purpose entities
Special purpose entities (SPEs) are typically set up for a single, discrete purpose, have a limited life and serve to legally isolate the financial assets held by the SPE from the selling organization. They are not operating entities and usually have no employees. SPEs may be variable interest entities (VIEs) as defined by CICA Accounting Guideline 15, Consolidation of Variable Interest Entities (AcG-15). Refer to the Critical accounting policies and estimates section and Notes 1 and 6 to our Consolidated Financial Statements, for our consolidation policy and information about the VIEs that we have consolidated, or in which we have significant variable interests. Pursuant to CICA Accounting Guideline 12, Transfers of Receivables (AcG-12), Qualifying SPEs (QSPE) are legal entities that are demonstrably distinct from the transferor, have limited and specified permitted activities, have defined asset holdings and may only sell or dispose of selected assets in automatic response to specified conditions.
     We manage and monitor our involvement with SPEs through our Structured Transactions Oversight Committee. Refer to the Risk management section for further details.
Securitization of our financial assets
We periodically securitize our credit card receivables and residential mortgage loans primarily to diversify our funding sources and enhance our liquidity position. We also securitize residential and commercial mortgage loans for sales and trading activities. Gains and losses on securitizations are included in Non-interest income. Refer to Note 1 to our Consolidated Financial Statements for our accounting policy for loan securitizations.
     In addition to traditional securitizations where we sell our loans and receivables, we also enter into synthetic securitizations to transfer risks relating to selected elements of our financial assets without actually transferring the assets through the use of certain financial instruments.
Credit card receivables
We securitize a portion of our credit card receivables through a SPE on a revolving basis. The SPE is funded through the issuance of senior and subordinated notes collateralized by the underlying credit card receivables. The issuances are rated by at least two of DBRS, Moody’s Investors Service (Moody’s) or Standard & Poor’s Corporation (S&P). This SPE meets the criteria for a QSPE and, accordingly, as the transferor of the credit card receivables, we are precluded from consolidating this SPE.
     We continue to service the credit card receivables sold to the QSPE and perform an administrative role for the QSPE. We also provide first-loss protection to the QSPE in two forms. We have an interest in the excess spread from the QSPE which is subordinate to the QSPE’s obligation to the holders of its asset-backed securities. Excess spread is the residual net interest income after all trust expenses have been paid. Our excess spread serves to absorb losses with respect to the credit card receivables before payments to the QSPE’s noteholders are affected. The present value of this excess spread is reported as a retained interest within our AFS securities on our Consolidated Balance Sheets. In addition, we provide loans to the QSPE to pay upfront expenses. These loans rank subordinate to all notes issued by the QSPE.
Residential mortgage loans
We securitize Canadian insured residential mortgage loans through the creation of mortgage-backed securities (MBS) and sell a portion of these MBS to an independent SPE on a revolving basis. We retain interests in the excess spread on the sold MBS and continue to service the underlying mortgages that we have securitized for funding and liquidity purposes.
     We did not securitize any residential mortgages synthetically in 2007. As at October 31, 2006, we had synthetically securitized $20 billion in residential mortgage loans through financial guarantees.
Commercial mortgage loans
We securitize commercial mortgages by selling them in collateral pools, which meet certain diversification, leverage and debt coverage criteria, to SPEs, one of which is sponsored by us. The SPEs finance the purchase of these pools by issuing certificates that carry varying degrees of subordination. The certificates issued by the SPE which we sponsor range from AAA to B- and are rated by any two of DBRS, Moody’s and S&P. The most subordinated certificates are unrated. The certificates represent undivided interests in the collateral pool, and the SPE which we sponsor, having sold all undivided interests available in the pool, retains none of the risk of the collateral pools. We do not retain any beneficial interests in the loans sold unless we purchase some of the securities issued by the SPEs for our own account. We are the primary servicer under contract with a third-party master servicer for the loans that are sold to the SPE that is sponsored by us.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  77

 

 

     
Our financial asset securitizations   Table 42
                 
(C$ millions)   2007     2006  
 
Outstanding securitized assets
                
Residential mortgages
   $ 18,384     $ 14,131  
Credit cards
     3,650       3,650  
Commercial mortgages
     3,727       1,914  
 
Total
   $ 25,761     $ 19,695  
 
Retained interests
                
Residential mortgages:
                
Mortgage-backed securities retained (1)
   $ 5,954     $ 5,591  
Retained rights to future excess interest
     414       206  
Credit cards:
                
Asset-backed securities purchased (2)
     870       1,390  
Retained rights to future excess interest
     27       26  
Subordinated loan receivables
     3       6  
Commercial mortgages
                
Asset-backed securities purchased (2)
     47       —  
 
Total
   $ 7,315     $ 7,219  
 
(1)   All residential mortgages securitized are Canadian insured mortgages.
 
(2)   Securities purchased during the securitization process.
Securitization activities during 2007
During the year, we securitized $13.3 billion of residential mortgages, of which $6.2 billion were sold and, $3.7 billion were reinvested in revolving securitizations and the remaining $3.4 billion were retained. We also securitized $1.9 billion of commercial mortgages and purchased $48 million (principal value) related securities during the securitization process. Refer to Note 5 to our Consolidated Financial Statements for further details and the amounts of impaired and past due loans that we manage and any losses recognized on securitization activities during the year.
Capital trusts
We issue innovative capital instruments, RBC Trust Capital Securities (TruCS) and RBC Trust Subordinated Notes (TSNs), through three SPEs: (i) RBC Capital Trust (Trust), (ii) RBC Capital Trust II (Trust II) and (iii) RBC Trust Subordinated Trust (Trust III). We consolidated Trust but do not consolidate Trust II or Trust III because we are not the Primary Beneficiary since we are not exposed to the majority of the expected losses, and we do not have a significant interest in these trusts. As at October 31, 2007, we held the residual interest of $1 million and $1 million (2006 — $1 million and nil) in Trust II and Trust III, respectively. We had a loan receivable of $40 million (2006 — $42 million) from Trust II and of $30 million from Trust III (2006 — nil), and reported the senior deposit notes of $900 million and $999.8 million (2006 — $900 million and nil) that we issued to Trust II and Trust III in our deposit liabilities. Under certain circumstances, TruCS of Trust II will be automatically exchanged for our preferred shares and TSNs exchanged for our subordinated notes without prior consent of the holders. In addition, TruCS holders of Trust II have the right to exchange for our preferred shares as outlined in Note 17 to our Consolidated Financial Statements.
     Interest expenses on the senior deposit notes issued to Trust II and Trust III amounted to $52 million and $23.6 million, respectively (2006 — $52 million and nil, 2005 — $52 million and nil) during the year. For further details on the capital trusts and the terms of the TruCS and TSNs issued and outstanding, refer to the Capital management section and Note 17 to our Consolidated Financial Statements.
Securitization of client financial assets
Within our Global Securitization Group, our principal relationship with SPEs comes in the form of administering seven multi-seller asset-backed commercial paper conduit programs (multi-seller conduits) – four in Canada and three in the United States. We are involved in the multi-seller conduit markets because our clients value these transactions, they offer us a growing source of revenue and they generate a favourable risk-adjusted return for us. Our clients primarily utilize multi-seller conduits to diversify their financing sources and to reduce funding costs by leveraging the value of high-quality collateral. The multi-seller conduits purchase various financial assets from clients and finance the purchases by issuing highly rated asset-backed commercial paper. The multi-seller conduits typically purchase the financial assets as part of a securitization transaction by our clients. In these situations, the sellers of the financial assets continue to service the respective assets and generally provide some amount of first-loss protection on the assets.
     The multi-seller conduits also financed assets that were either in the form of securities, including collateralized debt obligations (CDOs) or instruments that closely resemble securities such as credit-linked notes. The credit quality of these transactions is very high, often in the highest available rating categories established by the rating agencies that assign ratings to these types of securities or security-like instruments. In these situations, the multi-seller conduit is often one of many investors in the securities or security-like instruments.
     The commercial paper issued by each multi-seller conduit is in the multi-seller conduit’s own name with recourse to the financial assets owned by the multi-seller conduit. The multi-seller conduit commercial paper is non-recourse to us except through our participation in liquidity and/or credit enhancement facilities, and non-recourse to the other multi-seller conduits that we administer.
     We do not maintain any ownership or retained interests in these multi-seller conduits. We provide services such as transaction structuring and administration as specified by the multi-seller conduit program documents, for which we receive fees. In addition, we provide backstop liquidity facilities and partial credit enhancements to the multi-seller conduits. Our maximum exposure to loss under these facilities is $42.9 billion for 2007 and $35.1 billion for 2006. The increase in liquidity and credit facilities is due to the increase in the multi-seller conduits’ activities during the year. We have no rights to, or control of, the assets owned by the multi-seller conduits. Fee revenue for all such services, which is reported as Non-interest income, amounted to $72 million during the year (2006 — $60 million, 2005 — $58 million).
     Total commitments and amounts outstanding under liquidity and credit enhancement facilities for the multi-seller conduits as at October 31, 2007 and 2006, which are also included in our discussion in the Guarantees section, are shown below:
     
Liquidity and credit enhancement facilities
  Table 43
                                                 
    2007     2006  
            Maximum                     Maximum        
            exposure                     exposure        
(C$ millions)   Committed     to loss     Outstanding     Committed     to loss     Outstanding  
Backstop liquidity facilities
   $ 42,567     $ 38,726     $ —     $ 34,880     $ 31,686     $ —  
Credit enhancement facilities
     4,185       4,185       —       3,404       3,404       —  
 
Royal Bank of Canada: Annual Report 2007
78  Management’s Discussion and Analysis

 

 

     The following is a summary of our maximum exposure to loss categorized by securitized client asset type in the multi-seller conduits for the years ended October 31, 2007 and 2006.
     
Maximum exposure to loss categorized by client asset type   Table 44
                 
(C$ millions)   2007     2006  
 
Outstanding securitized assets
                
Auto loans and leases
   $ 12,157     $ 7,073  
Asset-backed securities
     164       195  
Consumer loans
     1,769       2,659  
Credit cards
     11,125       8,856  
Dealer floor plan receivables
     496       —  
Electricity market receivables
     306       306  
Equipment receivables
     2,279       2,132  
Insurance premiums
     610       664  
Other loans
     288       —  
Residential mortgages
     3,793       4,358  
Securities
     1,669       1,497  
Student loans
     2,654       2,928  
Trade receivables
     5,133       3,537  
Truck loans and leases
     468       885  
Other
     —       —  
 
Total
   $ 42,911     $ 35,090  
 
All the multi-seller conduits were restructured in 2004. As part of the restructurings, an unrelated third party (expected loss investor) agreed to absorb credit losses, up to a maximum contractual amount, that may occur in the future on the assets in the multi-seller conduits (multi-seller conduit first-loss position) before us and the multi-seller conduit’s debt holders. In return for assuming this multi-seller conduit first-loss position, the expected loss investor is paid by the multi-seller conduit a return commensurate with its risk position. Moreover, each multi-seller conduit has granted to the expected loss investor material voting rights, including the right to approve any transaction prior to the multi-seller conduit purchasing and financing a transaction. As a result of the restructurings, we do not consolidate any of the multi-seller conduits. As a result of increased activities during 2007, these seven multi-seller conduits have financial assets totalling $29.3 billion as at October 31, 2007 (2006 — $24.8 billion). The maximum assets that may have to be purchased by the conduits under purchase commitments outstanding as at October 31, 2007 were $41.8 billion (2006 — $34.3 billion).
Creation of credit investment products
We use SPEs to generally transform credit derivatives into cash instruments, to distribute credit risk and to create customized credit products to meet the needs of investors with specific requirements. As part of this process, we may transfer our assets to the SPEs with an obligation to buy these assets back in the future and may enter into derivative contracts with these SPEs in order to convert various risk factors such as yield, currency or credit risk of underlying assets to meet the needs of the investors. In this role as derivative counterparty to the SPE, we also assume the associated counterparty credit risk of the SPE.
     These SPEs often issue notes. The notes may be rated by external rating agencies, as well as listed on a stock exchange, and are generally traded via recognized bond clearing systems. While the majority of the notes are expected to be sold on a “buy and hold” basis, we may occasionally act as market maker. We do not, however, provide any SPE with guarantees or other similar support commitments; instead we buy credit protection from these SPEs through credit derivatives. The investors in the notes ultimately bear the cost of any payments made by the SPE under these credit derivatives. We consolidate the SPEs in which our investments in the notes expose us to a majority of the expected losses.
     There are many functions required to create such a product. We fulfill some of these functions and independent third parties or specialist service providers fulfill the remainder. Currently we act as sole arranger and swap provider for SPEs where we are involved and, in most cases, act as paying and issuing agent as well. As with all our trading derivatives, the derivatives with these SPEs are carried at fair value in derivative assets and liabilities.
     The assets in these SPEs amounted to $5.2 billion as at October 31, 2007 (2006 — $3.8 billion), of which $.3 billion were consolidated as at October 31, 2007 (2006 — $.7 billion). The majority of the increase in these assets is due to the creation of new SPEs in 2007.
Structured finance
We occasionally invest in off-balance sheet entities in the form of loan substitute and equity investments that are part of transactions structured to achieve a desired outcome, such as limiting exposure to specific assets or risks, obtaining indirect (and usually risk mitigated) exposure to financial assets, funding specific assets, supporting an enhanced yield and meeting client requirements. These transactions usually yield a higher return or provide lower-cost funding on an aftertax basis than financing non-SPE counterparties, holding an interest in financial assets directly, or receiving on-balance sheet funding. These transactions are structured to mitigate risks associated with directly investing in the underlying financial assets, or directly receiving funding, and may be structured so that our ultimate credit risk is that of a non-SPE, which in most cases is another financial institution. Exit mechanisms are built into these transactions to curtail exposure from changes in law or regulations. We consolidate structured finance VIEs in which our interests expose us to a majority of the expected losses. In 2007, we reduced our total investments in certain transactions. The unconsolidated entities in which we have significant investments or loans had total assets of $4.8 billion as at October 31, 2007 (2006 — $6.9 billion). At at October 31, 2007, our total investments in and loans to these entities were $2.5 billion (2006 — $2.9 billion), which are reflected on our Consolidated Balance Sheets.
Investment funds
We enter into derivative transactions with third parties including mutual funds, unit investment trusts and other investment funds for fees to provide their investors with the desired exposure and hedge our exposure from these derivatives by investing in other funds. We consolidate the investment funds when our participation in the derivative or our investment in other funds exposes us to a majority of the respective expected losses. The total assets held in the funds where we have significant exposure and which we did not consolidate were $1.6 billion as at October 31, 2007 (2006 — $3.6 billion). The decrease is primarily due to a reduction of assets in one of the investment funds. As at October 31, 2007, our total exposure was $423 million (2006 — $319 million).
Trusts, mutual and pooled funds
Our joint venture RBC Dexia IS provides global custody, fund and pension administration of client assets as well as the provision of shareholders services, foreign exchange, securities lending and other related services. With respect to trusteeship and/or custodian services for personal and institutional trusts, RBC Dexia IS has a fiduciary responsibility to act in the best interests of the beneficiaries of the trusts. RBC Dexia IS earns fees for providing these services and we include 50% of these fees in our revenue, representing our share of interest in the joint venture. Refer to Note 9 to our Consolidated Financial Statements for more details.
     We manage assets in mutual and pooled funds and earn fees at market rates from these funds, but do not guarantee either principal or returns to investors in any of these funds.
Guarantees
We issue guarantee products, as defined by the CICA Accounting Guideline 14, Disclosure of Guarantees (AcG-14), in return for fees recorded in Non-interest income. Significant types of guarantee products we have provided to third parties include credit derivatives, written put options, securities lending indemnifications, backstop liquidity facilities, financial standby letters of credit, performance guarantees, stable value products, credit enhancements, mortgage loans sold with recourse and certain indemnification agreements.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  79

 

 

     Due to the adoption of the three new financial instrument accounting standards on November 1, 2006, financial guarantees are now recognized at inception at the fair value of the obligation undertaken in issuing the guarantee. Subsequent measurement of financial guarantees at fair value is not required unless the financial guarantee qualifies as a derivative. As the carrying value of these financial guarantees does not reflect our maximum potential amount of future payments, we continue to consider guarantees as off-balance sheet arrangements. Prior to November 1, 2006, financial guarantees were required to be disclosed only in the notes to our Consolidated Financial Statements.
     Our maximum potential amount of future payments in relation to our guarantee products as at October 31, 2007, amounted to $152 billion (2006 — $125 billion). In addition, as at October 31, 2007, RBC Dexia IS securities lending indemnifications totalled $63.5 billion (2006 — $45.6 billion); we are exposed to 50% of this amount. The maximum potential amount of future payments represents the maximum risk of loss if there was a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions, insurance policies or collateral held or pledged.
     As at October 31, 2007, we had $40.4 billion in backstop liquidity facilities related to asset-backed commercial paper programs, of which 96% were committed to RBC-administered multi-seller conduits.
     Note 27 to our Consolidated Financial Statements provides detailed information regarding the nature and maximum potential exposure for the above-mentioned types of guarantee products.
Commercial commitments
We also provide commercial commitments to our clients to help them meet their financing needs. On behalf of our clients we undertake written documentary and commercial letters of credit, authorizing a third party to draw drafts on us up to a stipulated amount and typically having underlying shipments of goods as collateral. We make commitments to extend credit, which represent unused portions of authorizations to extend credit in the form of loans, bankers’ acceptances or letters of credit. We also have uncommitted amounts for which we retain the option to extend credit to a borrower. These guarantees and commitments exposed us to liquidity and funding risks. The following is a summary of our off-balance sheet commercial commitments.
     
Commercial commitments (1)   Table 45
                                         
(C$ millions)   Within 1 year     1 to 3 years     Over 3 to 5 years     Over 5 years     Total  
 
Documentary and commercial letters of credit
   $ 477     $ 24     $ —     $ —     $ 501  
Commitments to extend credit and liquidity facilities
     40,015       30,053       22,596       8,924       101,588  
Uncommitted amounts (2)
     47,110       —       —       —       47,110  
 
 
   $ 87,602     $ 30,077     $ 22,596     $ 8,924     $ 149,199  
 
(1)   Based on remaining term to maturity.
 
(2)   Uncommitted amounts represent an amount for which we retain the option to extend credit to a borrower.
RISK MANAGEMENT
Overview
Our business activities expose us to a wide variety of risks in virtually all aspects of our operations. We manage these risks by seeking to ensure that business activities and transactions provide an appropriate balance of return for the risk assumed and remain within our risk appetite.
     Our management of risk is supported by sound risk management practices and effective enterprise risk management frameworks. The cornerstone of these frameworks is a strong risk management culture, supported by a robust enterprise-wide set of policies, procedures and limits, which involve our risk management professionals, business segments and other functional teams. This partnership is designed to ensure the ongoing alignment of business strategies and activities within our risk appetite.
Risk appetite
Our risk appetite framework provides a structured approach to defining the amount and type of risk we are able and willing to accept in the pursuit of our business objectives. The risk appetite framework includes:
•   Identification of regulatory constraints that restricts our ability to accept risk and helps us to define our Risk Capacity, which represents the maximum amount and type of risk we can accept
•   Establishment and regular confirmation of Self-Imposed Constraints & Drivers where we have chosen to limit or otherwise influence the amount of risk we undertake
•   Translation of Risk Appetite into Risk Limits and Tolerances that guide our businesses in their risk taking activity
•   Periodic measurement and monitoring of our Risk Profile, which compares actual exposure to our established Risk Limits and Tolerances.
(RISK CAPACITY)
Risk management principles
We apply the following six overarching principles in the identification, monitoring and management of risk throughout the organization:
(i)   Balancing risk and reward is achieved through (a) aligning risk appetite with business strategy, (b) diversifying risk, (c) pricing appropriately for risk, (d) mitigating risk through preventive controls, and (e) transferring risk to third parties
 
(ii)   Management of risk is shared at all levels of the organization. Business management is accountable for all risks assumed in their operations, with direction and oversight provided by Group Risk Management (GRM), Global Technology and Operations (GTO), and Global Functions
 
(iii)   Effective decision-making is based on a strong understanding of risk
 
(iv)   All business activities are conducted with the view of not risking our reputation
 
(v)   Assuring that services we provide are suitable for and understood by our clients
 
(vi)   Applying appropriate judgment is required throughout the organization in order to manage risk.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  80

 

 

Risk governance
Our overall risk governance structure is presented below. It illustrates the roles and responsibilities of the various stakeholders.
(RISK GOVERNANCE)
Board and its committees
The Board of Directors provides oversight and carries out its risk management mandate through the Conduct Review and Risk Policy Committee (CR&RPC) and the Audit Committee.
     CR&RPC is designed to ensure that we have risk policies, processes and controls in place to manage significant risks and ensure compliance with the Bank Act (Canada) and other relevant laws and regulations.
     Audit Committee provides oversight over the integrity of the financial statements and reviews the adequacy and effectiveness of internal controls and the control environment, and ensures that policies related to liquidity, funding and capital management are in place.
Group Executive (GE) and Group Risk Committee (GRC)
GE is our senior management team and is led by our President and Chief Executive Officer (CEO). GE has overall responsibility for our strategy and its execution by establishing the “tone at the top.” Their risk oversight role is executed primarily through the mandate of GRC and the five supporting risk committees as follows:
•   The Asset and Liability Committee (ALCO) reviews, recommends, and approves policy frameworks pertaining to capital management, structural interest rate risk management, funds transfer pricing, liquidity and funding and subsidiary governance
•   The Ethics and Compliance Committee directly supports our management of regulatory, compliance and reputation risk
•   The Policy Review Committee acts as the senior risk approval authority relating to policies, products and services
•   The Structured Transactions Oversight Committee reviews structured transactions and complex credits
•   The USA Corporate Governance Committee is responsible for all corporate governance matters of our U.S. operations.
GRM and Corporate Treasury
GRM works in full partnership with our businesses to identify, assess, mitigate and monitor all forms of risk. Together with the CEO and other members of GE, the Chief Risk Officer (CRO) and GRM are primarily responsible for the promotion of our risk management culture. The CRO and GRM responsibilities include:
•   Establishing comprehensive risk identification and approval processes
•   Establishing appropriate methodologies for risk measurement
•   Establishing risk controls and limits to ensure appropriate risk diversification and optimization of risk and return on both a portfolio and transactional basis
•   Monitoring risk levels and reporting to senior management and the Board of Directors on major risks we assume or face
•   Acting as the catalyst in defining and communicating our risk appetite.
Corporate Treasury is responsible for the management, oversight and reporting of our capital position, structural interest rate risk, and liquidity and funding risks. Corporate Treasury recommends policies and authorities relating to the identification, measurement and management of liquidity and funding risk through ALCO and GRC for approval by the Audit Committee.
Business segments and corporate support groups
The business segments, GTO and Global Functions also have responsibility for the management of risk. These responsibilities include (i) accountability for their risks, (ii) alignment of business strategy with risk appetite, and (iii) identification, control and management of their risks.
Risk measurement
Our ability to measure risks is a key component of our enterprise-wide risk management process. Certain measurement methodologies are common to a number of risk types, while others only apply to a single risk type. While quantitative risk measurement is important, we also place reliance on qualitative factors. Our measurement models and techniques are continually subject to independent assessment by GRM for appropriateness and reliability. For those risk types that are hard to quantify, we place greater emphasis on qualitative risk factors and assessment of activities to gauge the overall level of risk in order to ensure that they are within our risk appetite.
Expected loss
Expected loss represents those losses that are statistically expected to occur in the normal course of business in a given period of time.
     With respect to credit risk, the key parameters used to measure our expected loss are the probability of default (PD), loss given default (LGD) and exposure at default (EAD). These parameters are determined based on historical experience, supplemented by benchmarking and updated on a regular basis, and are defined as follows:
•   PD: An estimated percentage that represents the probability that obligors within a specific rating grade or for a particular pool of exposures will default within a one-year period
•   LGD: An estimated percentage of EAD that is expected to be lost in the event of default of an obligor
•   EAD: An estimated dollar value of the expected gross exposure of a facility upon default of the obligor before specific provisions or partial write-offs.
With respect to trading market risk, we use a statistical technique known as Value-at-Risk to measure expected loss. It is a generally accepted risk management concept that uses statistical models to estimate within a given level of confidence the maximum loss in market value we would experience in our trading portfolio from an adverse one-day movement in market rates and prices. For further details, refer to the Market risk section.
Unexpected loss and Economic Capital
Unexpected loss is a statistical estimate of the amount by which actual losses can exceed expected loss over a specified time horizon, measured at a specified level of confidence. On an enterprise-wide basis, we use Economic Capital to estimate the unexpected loss associated with our business activities. We calculate Economic Capital by estimating the level of capital that is necessary to cover risks consistent with our desired solvency standard and desired debt rating.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  81

 

 

The use of Economic Capital as a risk measure enables us to assess performance on a comparable risk-adjusted basis at the transaction and portfolio levels. For further information, refer to the Capital management section.
Sensitivity analysis and stress testing
Sensitivity analysis and stress testing help us ensure that the risks we take remain within our risk appetite and that our level of capital remains adequate. Under sensitivity analysis, model inputs and assumptions are varied to assess how significantly the risk measure changes. Stress testing helps us determine the effects of potentially extreme market volatility on our portfolios. Stress scenarios are conservatively based on unlikely but possible adverse market events and economy-wide developments.
Model validation
To ensure robustness of our measurement techniques, model validation is carried out by our risk professionals independent of those responsible for the development and use of the models and assumptions.
Risk control
Our enterprise-wide risk management approach is supported by a comprehensive set of risk controls. This includes the development and communication of policies, establishment of formal risk review and approval processes, and the establishment of delegated authorities and limits. The implementation of robust risk controls enables the optimization of risk and return on both a portfolio and a transactional basis.
Risk policy architecture
Our risk management frameworks and policies are structured into the following four levels:
     
Level 1:
  Enterprise Risk Management Framework: This framework serves as the foundation of our risk management frameworks and policies, and sets the “tone at the top.”
Level 2:
  Risk-Specific Frameworks: These individual frameworks elaborate on each risk type and explain the following areas:
 
  •   Mechanisms for identifying, measuring, monitoring and reporting of risk
 
  •   Key policies
 
  •   Respective roles and responsibilities related to a specific risk.
Level 3:
  Enterprise Risk Policies: These policies are considered our minimum requirements for our business segments, GTO and Global Functions with respect to various risk types.
Level 4:
  Business Segments and GTO Specific Policies and Procedures: These policies and procedures are established by the business segments and GTO to manage the risks that are unique to their operations.
Risk review and approval processes
Our risk review and approval processes are established by GRM based on the nature, size and complexity of the risk involved. In general, the risk review and approval process involves a formal review and approval by an individual, group or committee that is independent from the originator. The approval responsibilities are governed by delegated authorities based on the following four categories:
•   Projects and Initiatives: Documentation of risk assessment is formalized through the requirement that each Project Appropriation Request (PAR) be reviewed and approved by GRM and Global Functions
 
•   New Products and Services: The policies and procedures for the approval of new or amended products and services have been developed to ensure that our products and services are subject to a broad and robust review and approval process that fully considers associated risks, while striving to facilitate business opportunities
 
•   Transactions: We ensure that risk assessment processes are in place for the review and approval of all types of transactions, including credit transactions
 
•   Structured Transactions and Complex Credits: The Structured Transactions Oversight Committee reviews new structured products and transactions with significant reputation, legal, accounting, regulatory or tax risks.
Authorities and limits
The Board of Directors, through the CR&RPC, delegates the setting of credit, market and insurance risk limits to the CEO, Chief Operating Officer (COO) and CRO. These delegated authorities allow these officers to set risk tolerances, approve geographic (country and region) and industry sector exposure limits within defined parameters, and establish underwriting and inventory limits for trading and investment banking activities. These delegated authorities are reviewed and approved annually by the Board of Directors and the CR&RPC. GRM is responsible for establishing:
•   The criteria whereby these authorities may be further delegated
 
•   The minimum requirements for documenting, communicating and monitoring the use of these delegated authorities.
CR&RPC must approve any transactions which exceed management’s delegated authorities.
     The Board of Directors through the Audit Committee approves risk limits for controlling liquidity and funding risk. These limits form part of our liquidity management framework and are a key risk control designed to ensure that reliable and cost-effective sources of cash are available to satisfy our current and prospective commitments, both on- and off-balance sheet.
Reporting
Enterprise level risk monitoring and reporting is a critical component of our enterprise risk management program and supports the ability of senior management and the Board of Directors to effectively perform their risk management and oversight responsibilities.
     Internal reporting is provided in the Enterprise Risk Report on a regular basis with the purpose of ensuring senior management and the Board of Directors receive timely and actionable forward-looking risk reporting on significant risk issues impacting our organization. We also have individual risk-specific reporting, which aligns with governance and relevant laws and regulations. Annually, the CRO provides the Board of Directors with a comprehensive review of emerging risks facing the organization as a whole as well as those facing the business segments. External reporting is provided as required by law and other relevant regulations. Regular reporting on risks is provided to stakeholders including regulators, external ratings agencies and analysts.
Basel II
As at November 1, 2007, we have implemented Basel II, which more closely aligns regulatory capital requirements with our underlying risk profile and internal risk management practices compared to Basel I. Basel II represents a major change in bank regulations, in that it allows banks to select from a menu of approaches to calculate the minimum capital required to support the credit risk and operational risks they undertake.
Royal Bank of Canada: Annual Report 2007
82  Management’s Discussion and Analysis

 

 

Credit risk
The Office of the Superintendent of Financial Institutions Canada (OSFI) expects each major bank in Canada to adopt the Advanced Internal Ratings Based (AIRB) Approach for all of its material portfolios, although some flexibility is permitted regarding the timing of adoption. For further details, refer to the Capital management section. Once our AIRB internal ratings systems have been approved by the OSFI, we are permitted to assess the credit risk of our exposures using our internal rating systems, and to employ the risk measurements produced by those ratings systems in the calculation of required regulatory capital.
Operational risk
The OSFI has been less prescriptive with respect to the calculation of capital for operational risk. The two options available to us under Basel II are the Standardized Approach and the Advanced Measurement Approach (AMA). We have elected to implement the more sophisticated risk management and governance practices that are required under AMA, but will initially use the Standardized Approach for the calculation of operational risk capital.
     The Standardized Approach provides the benefits of sounder operational risk management and governance, positioning us to migrate to AMA once advances in measurement capabilities warrant the adoption of a model-based calculation approach. The OSFI fully endorses this strategy of focusing on sound management of operational risk while working towards more advanced measurement capabilities.
Market risk
Basel II treatment of market risk is unchanged from the treatment under Basel I.
Risk Pyramid
We use a pyramid to identify and categorize our risks. These risks are organized vertically within the Risk Pyramid to reflect the degree of controllability. The Risk Pyramid provides us with a common language and discipline for the identification and assessment of risk in our businesses, products, initiatives, acquisitions and alliances. The Risk Pyramid is reviewed regularly to ensure that all key risks are reflected and ranked appropriately.
(RISK PYRAMID)
The base of the pyramid — The risk categories along the base of the Risk Pyramid are those over which we have the greatest level of control and influence. These are credit, market, liquidity and funding, and insurance risks. Operational risk, while still viewed as one of the risks over which we have the most control and influence, is ranked on a higher level than the other highly controllable risks. This ranking acknowledges the level of controllability associated with people, systems and external events.
The middle of the pyramid — Strategic and reputation risks, while more controllable than the risks at the top of the pyramid, are considered less controllable compared to the risks at the base of the pyramid. Strategic risk arises in one of two situations: (i) we choose the wrong strategy, or (ii) we choose the right strategy, but execute it poorly. Reputation risk is placed in the middle of the pyramid to denote the fair degree of control and influence we can use to manage this risk type, which generally occurs in connection with other risks, primarily regulatory and legal, and operational risks.
The top of the pyramid — Systemic risk is placed at the top of the Risk Pyramid, which is the least controllable and typically cannot be managed through any type of direct mitigation efforts, such as risk limits and/or portfolio diversification. Regulatory and legal and competitive risks, which can be viewed as somewhat controllable, can be influenced through our role as a corporate entity, and as an active participant in the Canadian and global financial services industry.
CREDIT RISK
Credit risk is the risk of loss associated with a counterparty’s inability or unwillingness to fulfill its payment obligations. Credit risk may be direct (issuer, debtor, obligor or policyholder) or indirect to a secondary obligor (guarantor or reinsurer).
     We offer a wide range of credit products and services to individual and business clients within Canada, the United States and in numerous countries. Core products offered include loans, residential and commercial mortgages, credit cards, lines of credit and letters of credit. Specialized credit services include asset-backed financing, margin lending, securities lending and project finance. The majority of our businesses offer credit products and services. Credit risk is also incurred through other activities not directly linked to the provision of credit products and services to clients, such as short-term investments relating to liquidity management and insurance business investment activities.
     Our credit offerings are a significant driver of overall business performance. The failure to effectively manage credit risk across the organization and all products, services and activities can have a direct, immediate and material impact on our earnings and reputation.
     Our credit risk management principles are guided by the six overall risk management principles discussed in the Risk management overview section. In particular, the following two principles are complemented by the items below with respect to credit risk management.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  83

 

 

The effective balancing of risk and return is achieved through:
•   Ensuring that credit quality is not compromised for growth
 
•   Diversifying credit risks in transactions, relationships and portfolios
 
•   Using our credit risk rating and scoring systems, policies and tools
 
•   Pricing appropriately for the credit risk taken
 
•   Applying consistent credit risk exposure measurements
 
•   Mitigating credit risk through preventive and detective controls
 
•   Transferring credit risk to third parties where appropriate through approved credit risk mitigation techniques, including hedging activities and insurance coverage.
Our business activities are conducted with the view of not risking our reputation. Therefore, there are certain types of clients and transactions that we avoid in order to maintain our reputation, such as:
•   Financing the manufacture of equipment or material for nuclear, chemical or biological warfare and landmines
 
•   Financing of Internet gambling businesses
 
•   Granting credit to entities subject to economic sanctions
 
•   Credit transactions that facilitate illegal activity, or contribute to misleading financial statements or regulatory reporting
 
•   Credit transactions involving undocumented agreements, disbursements or funds transfers
 
•   Granting credit to a business or individual engaged in activities inconsistent with generally accepted standards of ethical behaviour in the community.
Responsibilities
We deem credit risk management to be an enterprise-wide activity. The following provides a high-level overview of the key committees involved in the management of credit risk.
Board of Directors and Conduct Review & Risk Policy Committee
•   Shapes and influences credit risk culture; approves credit risk appetite.
 
•   Ensures that management has in place frameworks, policies, processes and procedures to manage credit risk (including approval authority for Credit Risk Management Framework and key enterprise-wide credit risk policies), and evaluates our effectiveness in managing credit risk.
 
•   Approves credit risk limits, delegates approval authorities to the CEO, COO, CRO, and approves credit transactions in excess of management’s authorities.
 
•   Reviews enterprise-wide credit reporting, significant exposures and exceptions to limits.
Group Risk Committee
•   Ensures credit risk profile is consistent with strategic objectives.
 
•   Ensures that there are ongoing, appropriate and effective risk management policies, processes and procedures to manage credit risk (including recommending the Credit Risk Management Framework and key enterprise-wide credit risk policies to the Board of Directors for approval).
 
•   Approves credit policies and products with significant risk implications, as referred by the CRO.
 
•   Recommends credit transactions in excess of management’s authority to the Board of Directors for approval.
 
•   Reviews enterprise-wide credit reporting, significant exposures and processes, and ensures that appropriate and timely information is provided to the Board of Directors on matters relating to credit risk and its management.
Policy Review Committee
•   Reviews and recommends approval of the Credit Risk Management Framework.
 
•   Approves enterprise-wide credit risk policies.
 
•   Approves new and amended business specific credit risk policies and products with significant risk implications.
Structured Transactions Oversight Committee
•   Provides risk oversight of structured transactions and complex credits, including identification and mitigation of risks.
 
•   Reviews and approves products and transactions referred to it in accordance with our policies.
Risk measurement
Given the potential for credit risk to significantly impact our earnings, it is critical that we accurately quantify credit risk at both the individual obligor and portfolio levels. This allows us to effectively estimate expected credit losses and minimize unexpected losses in order to manage and limit earnings volatility.
     Our credit risk exposures are classified as wholesale and retail portfolios, and we employ different risk measurement processes for each portfolio. The wholesale portfolio comprises business, sovereign and bank exposures, which include mid-size to large corporations and certain small businesses that are managed on an individual client basis. The retail portfolio is comprised of residential mortgages and personal, credit card and small business loans, which are managed on a pooled basis. This categorization of exposures is consistent with Basel II guidelines, which require banks to disclose their exposures based on how they manage their business and risks.
     Credit risk rating systems are designed to assess and quantify the risk inherent in credit activities in an accurate and consistent manner. We use a two-dimensional rating system for both wholesale and retail credit exposures.
Wholesale credit portfolio
The wholesale credit risk rating system is designed to measure and identify the risk inherent in our credit activities in an accurate and consistent manner along two dimensions.
     In the first dimension, each obligor is assigned a borrower risk rating (BRR), which reflects an assessment of the credit quality of the obligor. Each BRR has a probability of default (PD) assigned to it. This PD is an estimate of the probability that an obligor with a certain BRR will default within a one-year time horizon. The BRR differentiates the riskiness of obligors and represents our evaluation of the obligor’s ability and willingness to meet its contractual obligations despite
Royal Bank of Canada: Annual Report 2007
84  Management’s Discussion and Analysis

 

 

adverse or stressed business conditions, troughs in the business cycle, economic downturns or unexpected events that may occur. The assignment of BRRs is based on the evaluation of obligors’ business and financial performance against several risk factors. We use Risk Criteria Papers, which present a structured process for the consistent identification and analysis of material information needed to assess obligors in various industry sectors. Generally, the key risk factors assessed include industry, markets, firm competitiveness, company strategy and management quality, financial performance and access to funds. Risk Criteria Papers provide guidance on what to emphasize in the analysis of companies within an industry sector, and provide weightings, which may vary from industry to industry. Our internal risk ratings are reviewed at least on an annual basis.
     Our rating system is largely consistent with that of external rating agencies. The following table provides a mapping of our 22-grade internal risk ratings compared to ratings by external rating agencies.
     
Internal ratings map   Table 46
                   
            Moody’s Investors      
Rating     Standard & Poor’s     Service     Description
                   
1 to 4
    AAA to AA-     Aaa to Aa3      
                   
5 to 7
    A+ to A-     A1 to A3     Investment Grade
                   
8 to 10
    BBB+ to BBB-     Baa1 to Baa3      
                   
11 to 13
    BB+ to BB-     Ba1 to Ba3      
                   
14 to 16
    B+ to B-     B1 to B3     Non-investment Grade
                   
17 to 20
    CCC+ to CC     Caa1 to Ca      
                   
21 to 22
    C to D     C to Bankruptcy     Impaired/Default
                   
In the second dimension, loss given default (LGD) represents the portion of exposure at default (EAD) expected to be lost when an obligor defaults. LGD rates are largely driven by factors such as seniority of debt, collateral security, client type, and the industry in which the obligor operates. EAD represents an estimate of the expected gross exposure of a credit facility at the time of default of the obligor. At default the obligor may have drawn the facility fully or have repaid some of the principal. We estimate EAD based on the outstanding portion and an estimated amount of the undrawn portion that is expected to be drawn at the time of default. The estimation of these parameters represents a critical part of our credit rating system. It is a process of quantifying the risk associated with obligors and the related facilities by estimating and assigning values to the parameters. Parameter estimations are based on historical internal experience, and are benchmarked to external data where applicable. While PD is used at the obligor level, LGD and EAD are estimated for the various credit facilities under that obligor.
     These ratings and risk measurements are used in the determination of our expected losses, unexpected losses as well as economic and regulatory capital. They are also used in the setting of risk limits, portfolio management and product pricing.
Retail credit portfolio
Credit scoring is the primary risk rating system for assessing obligor and transaction risk for retail exposures. Credit scoring is employed in the acquisition of new clients (acquisition scoring) and portfolio management of existing clients (behavioural scoring).
     Acquisition scoring models, which are used for underwriting purposes, utilize established statistical methods of analyzing new applicant characteristics and past performance to estimate future credit performance. In model development, all accessible sources of data are used and include information obtained from the client (employment status), data from our own systems (loan information) and information from external sources (credit bureaus).
     Behavioural scoring is used in the ongoing management of retail clients with whom we have an established relationship. It utilizes statistical techniques that capture past performance to predict future behaviour and incorporate information such as cash flow and borrowing trends, as well as the extent of our relationship with the client. The behavioural risk score is dynamic and is generally updated on a monthly basis to continually re-evaluate the risk. Characteristics used in behavioural scoring models are based on information from existing accounts and lending products for each client, and from information obtained from external sources, such as credit bureaus.
     For overall portfolio management, retail exposures are assessed on a pooled basis, with each pool consisting of exposures that possess similar homogeneous characteristics. Pooling of exposures allows for more precise and consistent estimates of default and loss characteristics. Criteria used to pool exposures for risk quantification include behavioural score product type (mortgage, credit cards, lines of credit and installment loans), collateral type (chattel, liquid assets and real estate) and the delinquency status (performing, delinquent and default) of the exposure. Regular monitoring and periodic adjustments and alignments are conducted to ensure that this process provides for a meaningful differentiation of risk. It also allows the grouping of homogeneous exposures from a risk perspective and permits accurate and consistent estimation of loss characteristics at the pool level. Migration between the pools is considered when assessing credit quality.
     The pools are assessed in two dimensions: PD and LGD. The estimation of PD and EAD considers both borrower and transaction characteristics, including behavioural credit score, product type and delinquency status. The LGD is estimated based on transaction specified factors, including product and collateral types. Our risk ratings are reviewed and updated on a regular basis.
      The following table maps PD ranges to various risk levels:
     
Internal ratings map   Table 47
       
PD bands     Description
       
0.0%—1.0%     Low Risk
       
1.1%—6.4%     Medium Risk
       
6.5%—99.99%     High Risk
       
100.00%     Impaired/Default
       
Validation
We ensure that our credit risk rating systems and methodologies are subject to independent validation on a regular basis. The validation processes provide confirmation that our systems properly identify factors that help discriminate risk, appropriately quantify risk, produce measures of risk that respond to changes in the macroeconomic and credit environments, and are consistent with regulatory requirements and our ratings philosophy. Those responsible for performing validation activities are functionally separate from the group whose methodologies and processes are subject to validation.
     We ensure that there is proper separation of responsibility between (i) transaction origination and approval which takes place within the business segments, and (ii) design, development and maintenance of the risk rating methodologies, which takes place within GRM. GRM is also responsible for estimating the three risk parameters as described above. To ensure there is a proper segregation of responsibilities, models developed within the business segments are approved by GRM.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  85

 

 

     The validation of risk parameter estimation for both wholesale and retail portfolios addresses the estimation process and the reasonableness of the estimates used for the calculation of regulatory capital. The following items are examined and assessed:
•   Quantification methodologies and processes, as well as the reasonableness of outputs
 
•   Relationship between historical experience and internally derived parameter values that incorporate estimators’ expert judgment and external benchmarking
 
•   Sufficiency of data observations, the appropriateness of data sources and data segmentation
 
•   Statistical significance and predictive power of the estimated values. Levels of tolerance are defined and mapped against actual results, with deviations explicitly noted.
A combination of quantitative (statistical) and qualitative (non-statistical) validation methods is employed to ensure that our credit risk rating system is valid. At a minimum, we adopt the following techniques intended to ensure that the validation process:
•   Examines relevant and material data available from internal and external sources, to establish a context for assumptions, calculations and outputs
 
•   Demonstrates that estimates are grounded in historical experience
 
•   Provides reasonable predictors of future default and loss.
Detailed validation reports are produced for the assessment of risk rating methodology and risk parameter estimation.
Economic Capital
Economic Capital is management’s estimate of the amount of equity required to underpin our risks. It is used in risk-based pricing decisions and profitability measurement to ensure an appropriate risk and return balance. Within our wholesale credit portfolio, it is also used in setting single-name and industry limits in order to manage concentration risk. For further details, refer to the Capital management section.
Sensitivity and stress testing
Sensitivity and stress tests are used to determine the size of potential losses related to various scenarios for the wholesale and retail credit portfolios. While unexpected losses are, by nature difficult to quantify, we use stress testing, scenario and sensitivity analysis to better understand and mitigate unexpected credit losses. These activities serve to alert management to unlikely but possible adverse market events and economy-wide developments and implications on overall capital adequacy. Scenarios for credit risk such as economic or industry downturns, are chosen on the basis of being meaningful, representative of realistic potential events or circumstances, and reasonably conservative.
Risk control
Our enterprise-wide credit risk policies are developed, communicated and maintained by GRM. These policies set out the minimum requirements for the prudent management of credit risk in a variety of transactional and portfolio management contexts.
Credit risk policies
Our credit risk policies have evolved over many years as the organization has grown in geographic scope and product complexity, and have been refined based on experience, regulatory influences and innovations in risk management and are managed under six major categories as follows:
•   Credit Risk Assessment includes policies related to credit risk analysis, risk rating, risk scoring and trading credit
 
•   Credit Risk Mitigation includes credit structuring, collateral and guarantees
 
•   Credit Risk Approval includes credit risk limits and exceptions
 
•   Credit Documentation focuses on documentation and administration
 
•   Credit Review and Deterioration includes monitoring and review
 
•   Credit Portfolio Management includes portfolio management and risk quantification.
Approval of credit products and services
Our products and services are subject to robust risk review and approval processes. New or amended products and services must be reviewed relative to all risk types, including credit risk, in our Risk Pyramid, and as the level of risk increases, a more senior level of approval is required.
Credit risk limits
Limits are used to ensure our portfolio is well diversified and within our risk appetite as approved by the Board of Directors. Our credit limits are established at the following levels to ensure adequate diversification and to reduce concentration risk:
•   Single-name limits
 
•   Underwriting risk
 
•   Geographic (county and region) limits
 
•   Industry sector limits
 
•   Product and portfolio limits.
The Economic Capital limit is intended to work as a complement to the notional limits and, as such, single names must satisfy both limits. To ensure single-name credit risk exposure remains well under regulatory thresholds, and concentration risk is prudently managed, we have established (i) internal single-name credit risk exposure limits as a percentage of total capital, which are lower than that required by the OSFI, and (ii) a broader and more conservative definition of single-name credit risk exposure than that used by the OSFI. These controls provide a significant buffer between our exposure tolerances and those of our regulators. Exceptions are monitored by GRM and reported to the CRO, with requisite reporting to the CR&RPC in accordance with its mandate.
Credit risk mitigation
We seek to mitigate our exposure to credit risk through a variety of means, including structuring of transactions, collateral and credit derivatives. The policies and processes that are in place regarding the monitoring of the effectiveness of our credit risk mitigation are discussed below.
Structuring of transactions
Proper structuring of a credit facility is a key factor in mitigating risk at the transaction level and often includes the use of guarantees, security, seniority and covenants. We use credit policies and procedures to set out requirements for structuring transactions. Product-specific guidelines set out appropriate product structuring and client criteria.
Collateral
We generally require obligors to pledge collateral as security when we advance credit. This provides some protection in case of default. Real estate, liquid assets, cash, bonds and government securities are examples of the collateral securities we accept. The extent of risk mitigation provided by collateral depends on the amount type and quality of the collateral taken. Specific requirements relating to collateral valuation and management are documented in our credit risk management policies. GRM manages collateral positions through a system, which maintains information according to counterparty. Valuations of collateral are based on various sources and are compared to our collateral positions.
Royal Bank of Canada: Annual Report 2007
86  Management’s Discussion and Analysis

 

 

Credit derivatives
We also mitigate risk through credit derivatives that serve to transfer the risk to a third party. These derivatives are also used as a tool to mitigate industry sector concentration and single name exposure. Procedures are in place to ensure these hedges are efficient and effective.
     All derivative transactions supported by collateral are documented using industry-standard master agreements. Internal policies have been developed for each jurisdiction in order to ensure the legal enforceability of the collateral arrangements. Cash and securities held as collateral are held by us or by our authorized custodian. Concentration within the collateral taken is minimal.
     Credit valuation adjustments are made for derivative transactions which are exposed to changes in counterparty credit quality. Credit valuation adjustments are calculated at least once a month using internal models and GRM-approved methodology, which consist of sophisticated mathematical algorithms. The reasonableness of the level of valuation adjustments is independently verified on a monthly basis.
     Netting is a technique that can reduce credit exposure from derivatives and is generally facilitated through the use of master netting agreements. A master netting agreement provides for a single net settlement for all financial instruments covered by the agreement in the event of default on, or termination of, any one contract with the counterparty. Our trading units provide GRM with all relevant details of outstanding transactions, including itemized mark-to-market data. This data is used to monitor the amount of netting benefit recognized. For further details, refer to Note 7 to our Consolidated Financial Statements.
Reporting
GRM provides a number of enterprise level credit risk reports to senior management and the Board of Directors so as to ensure that shifts in our credit risk exposure or negative trends in our credit profile are highlighted and appropriate actions can be taken where necessary.
     An Enterprise Risk Report is distributed to the Board of Directors, Group Risk Committee and senior executives on a quarterly basis. The report provides a dynamic overview of our risk profile, including trending information and significant risk issues. It also includes analysis of significant shifts in exposures, expected loss, Economic Capital and risk ratings. Large exposure subject to credit policy exceptions, as well as significant counterparty exposure and downgrades are also reported. Analysis is provided on a portfolio and industry basis and includes the results of stress testing and sensitivity analysis.
     Separate business specific reports are also provided to senior management, who monitor the credit quality of their respective portfolios and emerging industry or market trends.
     
Loans and acceptances by portfolio and industry   Table 48
                                         
(C$ millions)
   2007     2006     2005     2004     2003  
 
Residential mortgages
   $ 109,745     $ 96,675     $ 91,043     $ 81,998     $ 75,790  
Personal
     48,743       44,902       41,045       36,848       32,186  
Credit cards
     8,322       7,155       6,200       6,456       4,816  
Small business (1)
     2,652       2,318       1,951       1,928       1,335  
 
Retail
   $ 169,462     $ 151,050     $ 140,239     $ 127,230     $ 114,127  
 
Business (2)
                                        
Agriculture
     5,367       5,435       5,238       4,992       4,789  
Automotive
     3,285       2,958       2,545       2,370       2,346  
Consumer goods
     5,206       4,553       4,437       4,566       4,920  
Energy
     7,632       6,010       5,628       3,462       3,621  
Non-bank financial services
     4,245       2,588       1,892       935       1,120  
Forest products
     1,349       1,126       1,210       1,150       1,523  
Industrial products
     4,119       3,659       3,157       2,827       2,952  
Mining and metals
     2,301       1,072       543       511       987  
Real estate and related
     19,187       16,145       13,730       12,224       12,286  
Technology and media
     2,423       2,326       2,244       2,135       2,723  
Transportation and environment
     2,656       2,400       1,900       2,555       3,196  
Other
     17,583       15,586       14,772       12,319       11,894  
Sovereign (3)
     932       887       550       800       732  
Bank
     5,468       3,252       903       668       1,176  
 
Wholesale
   $ 81,753     $ 67,997     $ 58,749     $ 51,514     $ 54,265  
 
Total loans and acceptances
   $ 251,215     $ 219,047     $ 198,988     $ 178,744     $ 168,392  
 
Total allowance for loan losses
   $ (1,493 )   $ (1,409 )   $ (1,498 )   $ (1,644 )   $ (2,055 )
 
Total loans and acceptances, net of allowance for loan losses
   $ 249,722     $ 217,638     $ 197,490     $ 177,100     $ 166,337  
 
(1)   Includes small business exposure managed on a pooled basis.
 
(2)   Includes small business exposure managed on an individual client basis.
 
(3)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
Credit portfolio analysis
2007 vs. 2006
During 2007, our credit portfolio remained well diversified and continued to show strong growth. Total loans and acceptances increased $32 billion, or 15%, compared to the prior year, reflecting continued growth in both our retail and wholesale loan portfolios.
Retail credit portfolio
Retail loans increased $18 billion, or 12%, from a year ago, largely due to solid growth across all categories in our Canadian loan portfolio.
     Residential mortgages were up $13 billion, or 14%, despite the offsetting effect of $13 billion of securitization during the year. The increase was supported by continued solid housing market activities in Canada, relatively low interest rates in a historical context, and strong labour market conditions.
     Personal loans grew $4 billion, or 9%, primarily reflecting strong growth in home equity lending in Canada, driven by continued solid housing market activities and favourable labour market conditions.
     Credit cards increased $1 billion, or 16%, reflecting successful sales efforts and continued consumer spending.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  87

 

 

Wholesale credit portfolio
Wholesale loans and acceptances were up $14 billion, or 20%, primarily reflecting strong growth across various sectors, with the largest increase in the Real estate and related, Bank and Energy sectors. Our Real estate and related exposure increased $3 billion, largely attributable to continued strong property development activities in Canada. Our exposure to the Bank sector was up $2 billion, with widespread increases across Canada, the U.S. and Other International. Our exposure to the Energy sector increased $2 billion, primarily reflecting continued investments by companies related to electricity generation, as well as oil and gas exploration and production in Canada.
Our portfolio remained well diversified and the overall mix did not change significantly from the prior year. The portfolio remained well balanced with residential mortgages comprising 44%, wholesale loans 33%, personal loans 19%, credit cards 3% and small business managed on a pooled basis 1%.
     The portfolio grew across all geographic regions. The largest increase was in Canada, with broad-based growth across both our retail and wholesale loan portfolios on generally favourable economic conditions. Growth in business lending accounted for most of the increase in the U.S. and Other International. For further details, refer to Table 59 in the Additional financial information section.
(BAR CHART)
Five-year trend
Over the last five years, total loans and acceptances continued to grow. Compared to 2003, our portfolio increased $83 billion, or 49%, driven by growth in both our retail and wholesale loan portfolios.
     Retail loans grew $55 billion, or 48%, since 2003, largely reflecting strong growth in Canada across all categories, particularly residential mortgages and personal loans, notwithstanding mortgage and credit card securitizations over the period. This growth reflected our continued focus on expanding our retail portfolios, underpinned by continued solid Canadian housing market activities, relatively low interest rates and strong labour market conditions.
     Our wholesale portfolio grew $27 billion, or 51%, since 2003. The largest growth sectors were Real estate and related, Bank, Energy and Non-bank financial services, primarily driven by strong loan demand in Canada amid generally favourable economic conditions over the period. The increase in Real estate and related exposure over the period was largely due to relatively strong North American housing markets combined with our U.S. acquisitions. While the U.S. housing market had been relatively solid over the past few years, it slowed down significantly in the latter part of 2007, which tempered loan growth. Our exposure to the Energy sector increased $4 billion, largely attributable to increased investments by companies related to oil and gas exploration and production in Canada and the U.S.
     Our portfolio in Canada continued to grow over the period, underpinned by our extensive distribution capabilities and continued product enhancement on the back of solid loan demand and generally favourable economic conditions. Our exposure in the U.S. and Other International generally trended downward except for the last three years, partly reflecting our strategic reduction in exposure to risk sensitive sectors, a reduction in single-name concentrations and our exit from non-core client relationships. With our successful strategic realignment in these areas, our exposure in the U.S. and Other International increased since 2005, primarily reflecting our successful market expansion initiatives, including acquisitions.
     
Credit derivatives position (notional amounts) (1)   Table 49
                                 
    2007     2006  
    Protection     Protection     Protection     Protection  
(C$ millions)   purchased (2)     sold (2)     purchased (2)     sold (2)  
 
Portfolio management
                                
Business
                                
Automotive
   $ 379     $ —     $ 272     $ 5  
Consumer goods
     —       67       —       92  
Energy
     957       —       273       7  
Non-bank financial services
     1,161       —       441       —  
Industrial products
     —       —       —       35  
Mining and metals
     591       —       95       —  
Real estate and related
     413       —       —       —  
Technology and media
     10       —       6       11  
Transportation and environment
     335       —       177       —  
Other
     472       119       520       142  
Sovereign (3)
     220       —       —       —  
Bank
     731       —       22       —  
 
Total portfolio management
   $ 5,269     $ 186     $ 1,806     $ 292  
 
(1)   Comprises credit default swaps, total return swaps and credit default baskets.
 
(2)   Net of offsetting protection purchased and sold in the amount of $261 million (2006 — $312 million).
 
(3)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
Royal Bank of Canada: Annual Report 2007
88  Management’s Discussion and Analysis

 

 

2007 vs. 2006
Total credit derivatives protection purchased increased $3 billion from the prior year. The credit protection bought was mainly related to the Non-bank financial services, Bank, Energy, and Mining and metals sectors, largely reflecting the acquisition of credit protection to mitigate single-name concentration risks in our portfolio. Our credit protection sold was down $106 million, or 36%, from a year ago. The decrease was mainly related to Industrial products, Consumer goods, and Technology and media sectors largely reflecting unfavourable U.S. financial market conditions.
Gross impaired loans and Allowance for credit losses
Loans are generally classified as impaired when there is no longer reasonable assurance of timely collection of the full amount of principal or interest.
     The allowance for credit losses is maintained at a level that management believes is sufficient to absorb probable losses in both the on- and off-balance sheet portfolios. The allowance is evaluated on a quarterly basis based on our assessment of problem accounts, recent loss experience and changes in other factors, including the composition and quality of the portfolio and economic conditions. The allowance is increased by the provision for credit losses (which is charged to income) and decreased by the amount of write-offs net of recoveries. For further information, refer to the Critical accounting policies and estimates section and Note 1 to our Consolidated Financial Statements.
     
Gross impaired loans continuity   Table 50
                                 
                    2007 vs. 2006  
(C$ millions, except percentage amounts)   2007     2006     Increase (decrease)  
 
Gross impaired loans, beginning of year
                                
Retail
   $ 383     $ 340     $ 43       13 %
Wholesale
     451       434       17       4  
 
 
   $ 834     $ 774     $ 60       8 %
New impaired loans
                                
Retail
   $ 926     $ 810     $ 116       14 %
Wholesale
     720       271       491       181  
 
 
   $ 1,646     $ 1,081     $ 607       56 %
Repayment, return to performing status, sold and other
                                
Retail
   $ (132 )   $ (144 )   $ 12       8 %
Wholesale
     (340 )     (164 )     (218 )     (133 )
 
 
   $ (472 )   $ (308 )   $ (206 )     (67 )%
Net impaired loan formations
                                
Retail
   $ 794     $ 666     $ 128       19 %
Wholesale
     380       107       273       255  
 
 
   $ 1,174     $ 773     $ 401       52 %
Write-offs
                                
Retail
   $ (759 )   $ (623 )   $ (136 )     (22 )%
Wholesale
     (109 )     (90 )     (19 )     (21 )
 
 
   $ (868 )   $ (713 )   $ (155 )     (22 )%
Gross impaired loans, end of year
                                
Retail
   $ 418     $ 383     $ 35       9 %
Wholesale
     722       451       271       60  
 
Total gross impaired loans
   $ 1,140     $ 834     $ 306       37 %
 
Key ratios
                                
Gross impaired loans as a % of loans and acceptances
     .45 %     .38 %     n.m.     7 bps
Total net write-offs as a % of average net loans and acceptances
     .30 %     .25 %     n.m.     5 bps
 
n.m.    not meaningful
     
Allowance for credit losses continuity   Table 51
                                 
                    2007 vs. 2006  
(C$ millions, except percentage amounts)   2007     2006     Increase (decrease)  
 
Specific allowance
                                
Balance, beginning of year
   $ 263     $ 282     $ (19 )     (7 )%
Provision for credit losses
     782       482       300       62  
Write-offs
     (868 )     (713 )     (155 )     (22 )
Recoveries
     170       205       (35 )     (17 )
Adjustments
     4       7       (3 )     (43 )
 
Specific allowance for credit losses, end of year
   $ 351     $ 263     $ 88       33 %
 
General allowance
                                
Balance, beginning of year
   $ 1,223     $ 1,286     $ (63 )     (5 )%
Provision for credit losses
     9       (53 )     62       117  
Adjustments
     (11 )     (10 )     (1 )     (10 )
 
General allowance for credit losses, end of year
   $ 1,221     $ 1,223     $ (2 )     —  
 
Allowance for credit losses
   $ 1,572     $ 1,486     $ 86       6 %
 
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  89

 

 

2007 vs. 2006
Total gross impaired loans (GIL) increased $306 million, or 37%, compared to the prior year, primarily reflecting higher impaired loans in our U.S. residential builder finance business triggered by the downturn in the U.S. housing market.
     Retail gross impaired loans increased $35 million, or 9%, from a year ago. The increase mainly reflected higher impairment in both U.S. and Canadian residential mortgages and small business loans commensurate with portfolio growth in Canada, partially offset by lower impaired Canadian personal loans.
     Wholesale gross impaired loans increased $271 million, or 60%, compared to the prior year. The increase was largely attributable to the Real estate and related sector, primarily reflecting higher impaired loans in our U.S. residential builder finance business as a result of the downturn in the U.S. housing market. This was partially offset by lower impaired loans in the Technology and media sector mainly due to the favourable resolution of a particular impaired loan.
     Gross impaired loans as a percentage of loans and acceptances were .45% compared to .38% in the prior year, primarily reflecting higher impaired loans in our U.S. residential builder finance business. For further details, refer to Table 60 in the Additional financial information section.
Allowance for credit losses
Total allowance for credit losses increased $86 million, or 6%, from a year ago, primarily reflecting increased specific allowance related to a weakening in credit quality of our U.S. residential builder finance loan portfolio.
     The specific allowance increased $88 million, or 33%, from the prior year. The increase was mainly driven by higher impaired loans in our U.S. residential builder finance business, primarily reflecting the downturn in the U.S. housing market.
     The general allowance remained relatively stable compared to the prior year, as an increase in allowance mainly related to our U.S. residential builder finance loan portfolio was offset by the impact of a stronger Canadian dollar on the translated value of our U.S. dollar-denominated allowance.
(BAR CHART)
*   GIL ratio: GIL as a percentage of loans and acceptances.
Five-year trend
Gross impaired loans
Gross impaired loans trended downward from 2003 to 2006, and decreased $911 million, or 52%, primarily reflecting lower impairment in our wholesale loan portfolio. In 2007, gross impaired loans increased $306 million, or 37%, from the prior year, largely due to higher impaired loans in our U.S. residential builder finance business as a result of the downturn in the U.S. housing market.
     Retail gross impaired loans remained relatively stable over the period. The increase in gross impaired loans in both U.S. and Canadian residential mortgages, primarily due to portfolio growth, was largely offset by a decrease in impairment in our Canadian personal loan portfolio over the period.
     Wholesale gross impaired loans generally trended downward from 2003 to 2006, and decreased $613 million, or 46%. The decline was across all geographic areas and most industry sectors, with the largest decrease in the Energy, Forest products, Transportation and environment, and Agriculture sectors due to generally favourable economic conditions over the period. In 2007, wholesale gross impaired loans increased significantly, largely reflecting higher impairment in our U.S. residential builder finance business triggered by the downturn in the U.S. housing market.
     The ratio of gross impaired loans as a percentage of loans and acceptances declined significantly from 1.04% in 2003 to .38% in 2006, and increased to .45% in 2007, reflecting the factors discussed above. For further details, refer to Table 60 in the Additional financial information section.
Allowance for credit losses
Over the last five years, total allowance for credit losses of $1,572 million in 2007, decreased $592 million, or 27%, from 2003, primarily reflecting a reduction in specific allowance.
     The specific allowance of $351 million in 2007 was down $406 million, or 54%, compared to 2003. For the period 2003 to 2006, the wholesale loan portfolio recorded the largest reduction in specific allowance, and was broad-based across portfolios, industry sectors and geographic regions. In 2007, specific allowance increased largely resulting from a weakening in credit quality of our U.S. residential builder finance loan portfolio driven by the downturn in the U.S. housing market.
     The general allowance of $1,221 million in 2007 decreased $186 million, or 13%, compared to 2003. The decrease was largely due to the reversal of general allowance of $175 million and $50 million in 2004 and 2006, respectively, largely reflecting improved credit quality and economic conditions in those years.
Royal Bank of Canada: Annual Report 2007
90 Management’s Discussion and Analysis

 

 

Provision for credit losses
The provision for credit losses is charged to income by an amount necessary to bring the allowance for credit losses to a level determined appropriate by management, as discussed in the Critical accounting policies and estimates section and Note 1 to our Consolidated Financial Statements.
     
Provision for (recovery of) credit losses   Table 52
                                 
                    2007 vs. 2006  
(C$ millions, except percentage amounts)   2007     2006     Increase (decrease)  
 
Residential mortgages
   $ 13     $ 6     $ 7       117 %
Personal
     364       306       58       19  
Credit cards
     223       163       60       37  
Small business (1)
     34       29       5       17  
 
Retail
   $ 634     $ 504     $ 130       26 %
 
Business (2)
   $ 148     $ (22 )   $ 170       n.m.  
Sovereign (3)
     —       —       —       —  
Bank
     —       —       —       —  
 
Wholesale
   $ 148     $ (22 )   $ 170       n.m.  
 
Total specific provision for loan losses
   $ 782     $ 482     $ 300       62 %
 
Total general provision
   $ 9     $ (53 )   $ 62       117 %
 
Total provision for credit losses
   $ 791     $ 429     $ 362       84 %
 
Specific PCL as a % of average net loans and acceptances
     .33 %     .23 %     n.m.     10 bps
 
(1)   Includes small business exposure managed on a pooled basis.
 
(2)   Includes small business exposure managed on an individual client basis.
 
(3)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
 
n.m.   not meaningful
2007 vs. 2006
Total provision for credit losses (PCL) increased $362 million, or 84%, compared to the prior year, which had been at a cyclically low level, and has trended up towards the historical average. The increase reflected higher provisions for both our wholesale and retail loan portfolios, primarily reflecting portfolio growth and higher impaired loans in our U.S. residential builder finance business triggered by the downturn in the U.S. housing market. Specific PCL as a percentage of average net loans and acceptances increased from a year ago, largely reflecting higher impaired loans in our U.S. residential builder finance business.
     Specific PCL for retail loans was up $130 million, or 26%, from a year ago. The increase was primarily attributable to higher provisions in our credit cards and personal unsecured credit line portfolios, largely reflecting higher loss rates and portfolio growth.
     Specific PCL for wholesale loans increased $170 million over the prior year. The increase was largely attributable to our business portfolio mainly due to higher impaired loans in our U.S. residential builder finance business and higher write-offs in Canada. Lower recoveries in our corporate loan portfolio this year also contributed to the increase in provisions.
     The general provision increased $62 million from a year ago, primarily reflecting a $50 million reversal of the general allowance related to our corporate loan portfolio in the prior year. Higher provisions in our U.S. residential builder finance loan portfolio, largely reflecting a weakening in credit quality as a result of the downturn in the U.S. housing market, also contributed to the increase.
(BAR CHART)
*   PCL ratio: Specific PCL as a percentage of average net loans and acceptances.
Five-year trend
During the period 2003 to 2005, specific provision for credit losses generally trended downward, primarily reflecting a reduction in provisions for our business loan portfolio. We recorded significant recoveries particularly in corporate loans in 2005 and 2006. In 2007, specific provisions has trended up towards the historical average, mainly reflecting higher provisions for our business loan portfolio, largely due to increased impaired loans in our U.S. residential builder finance business, portfolio growth and higher write-offs in Canada. Higher provisions in our personal loan and credit cards portfolios due to higher loss rates and portfolio growth also contributed to the increase. The specific provision as a percentage of average net loans and acceptances broadly declined from 2003 to 2006, largely due to a reduction in provisions for our business loan portfolio. The ratio increased to .33% in 2007, primarily reflecting higher impaired loans in our U.S. residential builder finance business. For further details, refer to Table 61 in the Additional financial information section.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 91

 

 

Market risk
Market risk is the risk of loss that may arise from changes in market factors such as interest rates, foreign exchange rates, equity or commodity prices, and credit spreads. We are exposed to market risk in our trading activity and our asset/liability management activities. The level of market risk to which we are exposed varies depending on market conditions, expectations of future price and yield movements and the composition of our trading portfolio.
Trading market risk
Trading market risk encompasses various risks associated with cash and related derivative products that are traded in interest rate, foreign exchange, equity, credit and commodity markets. Trading market risk is comprised of the following components:
•   Interest rate risk is the potential adverse impact on our earnings and economic value due to changes in interest rates. It is composed of: (i) directional risk — arising from parallel shifts in the yield curve, (ii) yield curve risk — arising from non-uniform rate changes across a spectrum of maturities, (iii) basis risk — resulting from an imperfect hedge of one instrument type by another instrument type whose changes in price are not perfectly correlated, and (iv) option risks — from changes in the value of embedded options due to changes in prices or rates and their volatility. Most financial instruments have exposure to interest rate risk.
 
•   Foreign exchange rate risk is the potential adverse impact on our earnings and economic value due to currency rate and precious metals price movements and volatilities. In our proprietary positions, we are exposed to the spot, forward and derivative markets.
 
•   Equity risk is the potential adverse impact on our earnings due to movements in individual equity prices or general movements in the level of the stock market. We are exposed to equity risk from the buying and selling of equities and indices as principal in conjunction with our investment banking activities and from our trading activities, which include tailored equity derivative products, arbitrage trading and relative value trading.
 
•   Commodities risk is the potential adverse impact on our earnings and economic value due to commodities price movements and volatilities. Principal commodities traded include crude oil, heating oil and natural gas. In our proprietary positions, we are exposed to the spot, forwards and derivative markets.
 
•   Credit spread risk is the general adverse impact on our earnings and economic value due to changes in the credit spreads associated with our holdings of instruments subject to credit risk.
 
•   Credit specific risk is the potential adverse impact on our earnings and economic value due to changes in the creditworthiness and default of issuers on our holdings in bonds and money market instruments, and those underlying credit derivatives.
We conduct trading activities over-the-counter and on exchanges in the spot, forward, futures and options markets, and we offer structured derivative transactions. Market risks associated with trading activities are a result of market-making, positioning, and sales and arbitrage activities in the interest rate, foreign exchange, equity, commodities, and credit markets. Our trading operations primarily acts as a market maker, executing transactions that meet the financial requirements of our clients and transferring the market risks to the broad financial market. We also act as principal and take proprietary market risk positions within the authorized limits granted by the Board of Directors. The trading book consists of cash and derivative positions that are held for short-term resale, taken on with the intent of benefiting in the short-term from actual or expected differences between their buying and selling prices or to lock in arbitrage profits.
Responsibilities
Oversight of market risk is provided by the Board of Directors through the Conduct Review & Risk Policy Committee (CR&RPC). Market risk limit approval authorities are established by the Board of Directors, upon recommendation of the CR&RPC, and delegated to senior management.
     The independent oversight of trading market risk management activities is the responsibility of Group Risk Management (GRM) — Market and Trading Credit Risk, which includes major units in Toronto, London, New York and Sydney. The Market and Trading Credit Risk group establishes market risk policies and limits, develops quantitative techniques and analytical tools, vets trading models and systems, maintains the Value-at-Risk (VaR) and stress risk measurement systems, and provides enterprise risk reporting on trading activities. This group also provides independent oversight on trading activities, including the establishment and administration of trading operational limits, market risk and counterparty credit limit compliance, risk analytics, and the review and oversight of non-traditional or complex transactions.
     Business segments are accountable for their market risks, working in partnership with GRM to ensure the alignment between risk appetite and business strategies.
     GRM — Market and Trading Credit Risk is responsible for the determination and reporting of regulatory and Economic Capital requirements for market risk, and provides assurance to regulators in regular filings on reporting accuracy, timeliness and the proper functioning of statistical models within the approved confidence level.
Risk measurement
We employ risk measurement tools such as VaR, sensitivity analysis and stress testing. GRM uses these measures in assessing global risk-return trends and to alert senior management to adverse trends or positions.
     The majority of trading positions in foreign exchange, interest rate, equity, commodity and credit trading have capital calculated under an internal models approach while structured credit derivatives are calculated under the Standardized Approach. Also calculated under the Standardized Approach for migration and default (specific) risk are a limited set of interest rate products. These products and risks are not included in our global VaR.
Value-at-Risk (VaR)
VaR is a statistical technique that measures the worst-case loss expected over the period within a 99% confidence level. Larger losses are possible, but with low probability. For example, based on a 99% confidence interval, a portfolio with a VaR of $20 million held over one day would have a one in one hundred chance of suffering a loss greater than $20 million in that day. VaR is measured over a 10-day horizon for the purpose of determining regulatory capital requirements.
     We measure VaR by major risk category on a discrete basis. We also measure and monitor the effects of correlation in the movements of interest rates, credit spreads, exchange rates, equity and commodity prices and highlight the benefit of diversification within our trading portfolio. This is then quantified in the diversification effect shown in our Global VaR table on the following page.
     As with any modeled risk measure, there are certain limitations that arise from the assumptions used in VaR. Historical VaR assumes that the future will behave like the past. As a result, historical scenarios may not reflect the next market cycle. Furthermore, the use of a 10-day horizon VaR for risk measurement implies that positions could be unwound or hedged within 10 days but this may not be a realistic assumption if the market becomes largely or completely illiquid. For example, this was observed for certain U.S. subprime-related securities since August 2007. VaR is calculated based on end-of-day positions.
Validation
To ensure VaR effectively captures our market risk, we continuously monitor and enhance our methodology. Daily back-testing serves to compare hypothetical profit or loss against the VaR to monitor the statistical validity of 99% confidence level of the daily VaR measure.
Royal Bank of Canada: Annual Report 2007
92 Management’s Discussion and Analysis

 

 

Back-testing is calculated by holding position levels constant and isolating the effect of the movement of actual market rates over the next day and over the next 10 days on the market value of the portfolios. Intra-day position changes account for most of the difference between theoretical back-testing and actual profit and loss. VaR models and market risk factors are independently reviewed periodically to further ensure accuracy and reliability. In 2007, there were five occurrences of a back-test exceeding VaR. This occurred during the volatile markets of July and August. VaR calculated using a historical window can lead to back-testing breaches when the historical window used in the calculation is less volatile than current markets. During this period, we frequently updated our scenarios to keep pace with current market events.
Sensitivity analysis and stress testing
Sensitivity analysis is used to measure the impact of small changes in individual risk factors such as interest rates and foreign exchange rates and is designed to isolate and quantify exposure to the underlying risk.
     VaR is a risk measure that is only meaningful in normal market conditions. To address more extreme market events, stress testing is used to measure and alert senior management to our exposure to potential political, economic or other disruptive events. We run several types of stress testing, including historical stress events such as the 1987 stock market crash, as well as hypothetical “what-if” stress events that represent potential future events that are plausible but have a very low probability of occurring. Our stress scenarios are reviewed and updated as required to reflect relevant events and hypothetical situations. While we endeavour to be conservative in our stress testing, there can be no assurance that our stress testing assumptions will cover every market scenario that may unfold.
Risk control
Policies
A comprehensive risk policy framework governs trading-related risks and activities and provides guidance to trading management, middle office compliance functions and operations. We employ an extensive set of principles, rules, controls and limits, which conform to industry best practice. Our market risk management framework is designed to ensure that our risks are appropriately diversified on a global basis. Limits on measures such as notional size, term and overall risk are monitored at the desk, and at the portfolio and business levels.
Reporting
Reports on trading risks are provided by GRM — Market and Trading Credit Risk to the Chief Risk Officer (CRO) and the operating committee of Capital Markets on a weekly basis and to senior management on a daily basis. Enterprise-wide reporting is used to monitor compliance against VaR and stress limits approved by the Board of Directors, and the operating limits derived from these board limits. In addition to this monitoring, GRM — Market and Trading Credit Risk pre-approves excesses and reports any breach to the CRO and the operating committee of Capital Markets.
     Internal reporting to senior management includes stand-alone risk calculations for portfolios that have standardized regulatory capital which are then combined with models-based results to present an aggregated enterprise risk profile.
     The following table shows our global VaR for total trading activities under our models based approach for capital by major risk category and also shows the diversification effect, which is calculated as the difference between the global VaR and the sum of the separate risk factor VaRs.
     
Global VAR by major risk category   Table 53
                                                                   
    2007       2006  
       
    As at     For the year ended October 31       As at     For the year ended October 31  
(C$ millions)   Oct. 31     High     Average     Low       Oct. 31     High     Average     Low  
       
Equity
   $ 8     $ 18     $ 9     $ 4       $ 7     $ 11     $ 7     $ 5  
Foreign exchange
     4       7       2       1         2       4       2       1  
Commodities
     2       2       1       —         1       2       1       —  
Interest rate
     20       23       19       14         13       20       13       9  
Credit specific
     3       5       3       2         3       4       3       2  
Diversification
     (19 )     n.m.       (13 )     n.m.         (9 )     n.m.       (8 )     n.m.  
Global VAR
   $ 18     $ 27     $ 21     $ 16       $ 17     $ 25     $ 18     $ 13  
       
n.m.   not meaningful
(LINE GRAPH)
Global VaR
2007 vs. 2006
Average global VaR for the year of $21 million was up compared to $18 million a year ago. This increase largely reflected an increase in both Interest rate and Equity VaR due to a higher level of trading activity and increased market volatility during the current year. These increases were mostly offset by an improvement in the overall diversification effect, which rose to 38% compared to 31% a year ago.
Trading revenue
2007 vs. 2006
The volatility in daily trading revenue in the latter part of 2007 reflected difficult trading conditions in both interest rates and credit-related products arising from a very stressed market during that period. Equity markets also experienced high volatility in July and August. Writedowns related to the valuation of U.S. subprime RMBS and CDOs of ABS in our Structured Credit business totalled $357 million. In addition to this
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis 93

 

 

one-day trading loss, we experienced 25 days of net trading losses with the largest one-day loss of $23 million.
(GRAPH)
(GRAPH)
(1)   Trading revenue on a taxable equivalent basis excluding revenue related to consolidated VIEs.
(2)   The $357 million writedown on the valuation of U.S. subprime RMBS and CDOs of ABS was included on October 31, 2007.
Non-trading market risk (Asset/liability management)
Traditional non-trading banking activities, such as deposit taking and lending, expose us to market risk, of which interest rate risk is the largest component.
     Our goal is to manage the interest rate risk of the non-trading balance sheet to a target level. We modify the risk profile of the balance sheet through proactive hedging to achieve our target level. For additional information regarding the use of derivatives in asset and liability management, refer to the Off-Balance sheet section and Note 7 to our Consolidated Financial Statements. We continually monitor the effectiveness of our interest rate risk mitigation activity within Corporate Treasury on a value and earnings basis.
     For a discussion of the management of foreign exchange risk in the non-trading balance sheet, refer to the Hedging foreign currency-denominated operations discussion in the Capital management section.
Responsibilities
While our individual subsidiaries and business segments manage the daily activities, Corporate Treasury is responsible for managing our enterprise-wide interest rate risk, monitoring approved limits and compliance with policies and operating standards. Our Asset and Liability Committee (ALCO) provides oversight to Corporate Treasury and reviews the policy developed by Corporate Treasury and provides recommendations to CR&RPC for approval.
Risk measurement
We endeavour to keep pace with best practices in instrument valuation, econometric modeling and new hedging techniques on an ongoing basis. Our investigations range from the evaluation of traditional asset/liability management processes to pro forma application of recent developments in quantitative methods.
     Our risk position is measured daily, weekly or monthly based on the size and complexity of the portfolio. Measurement of risk is based on rates charged to clients as well as funds transfer pricing rates. Key rate analysis is utilized as a primary tool for risk management. It provides us with an assessment of the sensitivity of the exposure of our economic value of equity to instantaneous changes in individual points on the yield curve.
     The economic value of equity is equal to the net present value of our assets, liabilities and off-balance sheet instruments.
Funds transfer pricing
We use a funds transfer pricing mechanism at the transaction level to transfer interest rate risk to Corporate Treasury and identify the profitability of various products. The funds transfer pricing rates are market-based and are aligned with interest rate risk management principles. They are supported by empirical research into client behaviour and are an integral input to the retail business pricing decisions.
     We also focus on developing retail product valuation models that incorporate the impact of consumer behaviour. These valuation models are typically derived through econometric estimation of consumer exercise of options embedded in retail products. The most significant embedded options are mortgage rate commitments and prepayment options. In addition, we model the sensitivity of the value of deposits with an indefinite maturity to interest rate changes.
Validation
We supplement our assessment by measuring interest rate risk for a range of dynamic and static market scenarios. Dynamic scenarios simulate our interest income in response to various combinations of business and market factors. Business factors include assumptions about future pricing strategies and volume and mix of new business, whereas market factors include assumed changes in interest rate levels and changes in the shape of the yield curve. Static scenarios supplement dynamic scenarios and are employed for assessing the risks to the value of equity and net interest income.
     As part of our monitoring of the effectiveness of our interest rate risk mitigation activity within Corporate Treasury which is done on a value and earnings basis, model assumptions are validated against actual client behaviour.
Risk control
Policies and limits
The interest rate risk policies define the management standards and acceptable limits within which risks to net interest income over a 12-month horizon, and the economic value of equity, are to be contained. These ranges are based on immediate and sustained ± 100 basis point parallel shift of the yield curve. The limit for net interest income risk is 3% of projected net interest income, and for economic value of equity risk, the limit is 5% of projected common equity. Interest rate risk policies and limits are reviewed and approved annually by the Board of Directors.
Royal Bank of Canada: Annual Report 2007
94 Management’s Discussion and Analysis

 

 

Risk reporting
The individual subsidiaries and business segments report the interest rate risk management activity on a monthly basis. They must also immediately report any exceptions to the interest rate risk policies to Corporate Treasury and seek approval of the corrective actions.
     An Enterprise interest rate risk report is reviewed monthly by the ALCO and quarterly by the Group Risk Committee and the Board of Directors.
 
Market risk measures — Non-trading banking activities   Table 54
                                                                                 
    2007     2006     2005  
    Economic value of equity risk     Net interest income risk                    
    Canadian     U.S.             Canadian     U.S.             Economic     Economic        
    dollar     dollar     All     dollar     dollar     All     value     Net interest     value     Net interest  
(C$ millions)   impact     impact (1)     currencies     impact     impact (1)     currencies     of equity risk     income risk     of equity risk     income risk  
 
Before-tax impact of: 100bp increase in rates
   $ (391 )   $ (49 )   $ (440 )   $ 40     $ 14     $ 54     $ (496 )   $ 87     $ (435 )   $ 106  
100bp decrease in rates
     315       (6 )     309       (97 )     (14 )     (111 )     375       (153 )     291       (181 )
Before-tax impact of: 200bp increase in rates
     (819 )     (111 )     (930 )     68       29       97       (1,044 )     147       (920 )     162  
200bp decrease in rates
     640       (87 )     553       (202 )     (29 )     (231 )     658       (319 )     461       (365 )
 
(1)   Represents the impact on the non-trading portfolios held in our U.S. banking operations.
2007 Analysis
The above table provides the potential before-tax impact of an immediate and sustained 100 basis point and 200 basis point increase or decrease in interest rates on net interest income and economic value of equity of our non-trading portfolio, assuming that no further hedging is undertaken. These measures are based upon assumptions made by senior management and validated by empirical research. All interest rate risk measures are based upon interest rate exposures at a specific time and continuously change as a result of business activities and our risk management initiatives. Over the course of 2007, our interest rate risk exposure was well within our target level.
OPERATIONAL RISK
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
     Operational risk is embedded in all our activities, including the practices and controls used to manage other risks. Failure to manage operational risk can result in direct or indirect financial loss, reputational impact, regulatory censure, or failure in the management of other risks such as credit or market risk.
     Our operational risk management framework flows directly from our enterprise risk management framework and sets out the principles and practices that we use to manage operational risk by identifying, measuring, controlling, and monitoring and reporting it. During 2007, we strengthened our operational risk management framework by expanding the common operational risk language that supports the consistent identification, assessment and understanding of risks. We also implemented our “converged” operational risk and control assessment and monitoring program. This enterprise-wide program integrated several stand-alone programs to identify and assess operational risks.
Responsibilities
The Board of Directors is responsible for providing oversight and ensuring that appropriate policies have been implemented to manage operational risk. The Chief Risk Officer (CRO) and Group Risk Management (GRM) are responsible for implementing the operational risk management framework on an enterprise-wide basis, as well as for directing and approving significant area-specific operational risk policies. A dedicated team within GRM designs and supports operational risk policies, programs and initiatives, and monitors implementation progress and ongoing execution. The businesses and corporate support groups are responsible for the informed and active management of the operational risks within their activities in accordance with the operational risk management framework. Where appropriate, execution of operational risk management programs is conducted by GTO on behalf of the businesses and corporate support groups.
Risk measurement
Operational risk is difficult to measure in a complete and precise manner, given that exposure to operational risk is often implicit, bundled with other risks, or otherwise not taken on intentionally. In the banking industry, measurement tools and methodologies continue to evolve. Nonetheless, we are able to gauge our operational risk exposure by using several approaches concurrently.
Risk assessment
Operational risks are identified and their potential impact assessed through our enterprise-wide integrated operational risk and control assessment and monitoring program. Our operational risk management framework is used to ensure consistent identification and assessment of operational risks and the controls used to manage these.
Risk indicators
Our businesses and corporate support groups use a broad range of risk indicators to manage their day-to-day activities. GRM uses indicators to monitor operational risk at the enterprise level. These indicators provide insight into the level and composition of our operational risk exposure and potential changes in these.
Operational event data collection and analysis
Operational risk events are reported in a central enterprise database. Comprehensive information about these events is then collected, and includes information regarding amount, occurrence, discovery date, business area and product involved, root causes and risk drivers. Analysis of operational risk event data helps us to understand where and how our risks are manifesting themselves, provides a historical perspective of our operational risk experience, and establishes a basis for measuring our operational risk exposure and the capital needed to underpin this type of risk.
Industry loss analysis
We review and analyze information on operational losses that have occurred at other financial institutions, using published information and information we acquire through our membership in the Operational Riskdata eXchange (ORX), a private data-sharing
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Management’s Discussion and Analysis 95

 

 

consortium. Both provide insights into the size and nature of potential exposures, which enables us to benchmark our loss experience against those of our peers to determine if our experience puts us in an outlier position. It also allows us to monitor emerging developments and trends that affect the financial industry as a whole.
Risk control
Operational risk is managed through our infrastructure, controls, systems and people, complemented by central enterprise-wide groups focusing on management of specific operational risks such as fraud, privacy, outsourcing, and business disruption, as well as people and systems risks.
     A number of our enterprise-wide groups ensure that all of these controls and systems are effective under our operational risk management framework. These include compliance, which ensures a complete view of our regulatory obligations and provides a co-ordinated, effective response to these, and the internal audit group, which provides independent assessment of risk management practices, internal controls and corporate governance processes.
Risk mitigation
Any high-risk exposures that we identify are subject to remedial measures, monitoring and control testing. This includes exposures identified through our integrated risk and control assessment and monitoring program, internal audits, compliance reviews, business continuity readiness reviews, or operational risk event reporting.
     Our corporate insurance program enables us to transfer some of our operational risk exposure by purchasing insurance coverage, the nature and amounts of which are determined on a central, enterprise-wide basis.
Reporting
GRM provides quarterly enterprise level risk reporting to senior management and the Board of Directors. The operational risk reporting includes an overview of our operational risk profile and the trend and outlook for our exposure. Details are provided on areas of elevated risk, individual operational risks where there is heightened awareness, regulatory or compliance issues, and large operational risk events. This reporting is supplemented with more detailed specific reporting by groups such as compliance, audit, legal and human resources.
LIQUIDITY AND FUNDING RISK
Liquidity and funding risk is the risk that an institution is unable to generate or obtain sufficient cash or its equivalent in a timely and cost-effective manner to meet its commitments as they come due.
     Our liquidity and funding management framework is designed to ensure that adequate sources of reliable and cost-effective cash or its equivalents are continually available to satisfy our current and prospective financial commitments under normal and contemplated stress conditions. To achieve this goal, we are dedicated to the preservation of the following key liquidity and funding risk mitigation strategies:
•   A large base of core client deposits
•   Continual access to diversified sources of wholesale funding, including demonstrated capacities to monetize specific asset classes
•   A comprehensive and enterprise-wide liquidity contingency plan supported by an earmarked pool of unencumbered marketable securities (referred to as “contingency liquidity assets”) that provide assured access to cash in a crisis.
Our liquidity and funding management practices and processes reinforce these risk mitigation strategies by assigning prudential limits or targets to metrics associated with these activities and regularly measuring and monitoring various sources of liquidity risk under both normal and stressed market conditions. In managing this risk, we aim to achieve a prudent balance between the level of risk we take and the cost of its mitigation, recognizing that this balance may need to be adjusted if our internal and/or external environments change materially.
Responsibilities
The Board of Directors is responsible for oversight of our liquidity and funding management framework, which is developed and implemented by senior management.
•   The Audit Committee approves our liquidity and funding management framework, our pledging framework, and liquidity contingency plan and establishes broad liquidity risk tolerance levels, and the Board of Directors is informed on a periodic basis about our current and prospective liquidity condition.
•   The Group Risk Committee and our Asset and Liability Committee (ALCO) share management oversight responsibility for liquidity and funding policies and receive regular reports detailing compliance with key limits and guidelines.
•   Corporate Treasury has global responsibility for the development of liquidity and funding management policies, strategies and contingency plans and for recommending and monitoring limits within the framework. In this role, Corporate Treasury is assisted by Group Risk Management. Corporate Treasury actively participates in national and international industry initiatives to benchmark and enhance its liquidity management practices.
•   Treasury departments of business segments and key subsidiaries execute transactions in line with liquidity management policies and strategies.
•   Subsidiaries are responsible for managing their own liquidity in compliance with policies and practices established under advice and counsel by Corporate Treasury and within governing regulatory requirements.
Risk measurement
The assessment of our liquidity position reflects management’s conservative estimates, assumptions and judgments pertaining to current and prospective firm-specific and market conditions and the related behaviour of our clients and counterparties. We measure and manage our liquidity position from three risk perspectives as follows:
Structural liquidity risk
Structural liquidity risk management addresses the risk due to mismatches in effective maturities between assets and liabilities, more specifically the risk of over-reliance on short-term liabilities to fund longer-term illiquid assets. We use both the cash capital and survival horizon models to assist in the evaluation of balance sheet liquidity and determination of the appropriate term structure of our debt financing. These methodologies also allow us to measure and monitor the relationship between illiquid assets and core funding, including our exposure to a protracted loss of unsecured wholesale deposits under stressed conditions.
Tactical liquidity risk
Tactical liquidity risk management addresses our normal day-to-day funding requirements, which are managed by imposing prudential limits on net fund outflows in Canadian dollar and foreign currencies for key short-term time horizons, as well as on our pledging activities that are subject to an enterprise-wide framework that assigns a risk-adjusted limit to our aggregate pledging exposure and individual limits by types of pledging activities. Pledged assets include a pool of eligible assets that are reserved exclusively to support our participation in payment and settlement systems.
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96 Management’s Discussion and Analysis

 

 

Contingent liquidity risk
Contingent liquidity risk management assesses the impact of and our intended responses to sudden stressful events. The liquidity contingency plan identifies comprehensive action plans that would be implemented depending on the duration and severity of the various liquidity crises identified in our stress testing program. Corporate Treasury maintains and administers the liquidity contingency plan. The Liquidity Crisis Team, consisting of senior representatives of all key business and functional units, meets regularly to engage in stress testing and to review our liquidity contingency preparedness.
     Our stress testing exercises are based on models that measure our potential exposure to global, country-specific or RBC-specific events (or a combination thereof) and consider both historical and hypothetical events. Different levels of severity are considered for each type of crisis including ratings downgrades of two and four notches and to non-investment grade for RBC-specific events. These comprehensive tests include elements of scenario and sensitivity stress testing techniques. In all cases, the crisis impact is measured over a nine-week horizon, which is also used in our key measure of tactical liquidity risk and is what we consider to be the most crucial time span for a liquidity event. Liquidity Crisis Team members contribute to assumptions about the expected behaviour of balance sheet asset and liability categories and off-balance sheet exposures based on their specialized client, product and market perspectives. Some tests are run monthly, others are only run annually. Frequency is determined by considering a combination of their likelihood and impact. After reviewing test results, the liquidity contingency plan and other related liquidity and funding risk management practices may be modified in light of lessons learned. Failure to meet predetermined minimum targets in some of these tests, as well as in aforementioned risk measures, would result in discussion with senior management and, as necessary, the Board of Directors, and possibly lead to revised limits and targets.
     Our liquid assets are primarily a diversified pool of highly rated marketable securities and include segregated portfolios (in both Canadian and U.S. dollars) of contingency liquidity assets to address potential on- and off-balance sheet liquidity exposures (such as deposit erosion, loan drawdowns and higher collateral demands), that have been estimated through models we have developed or by the scenario analyses and stress tests that we conduct periodically. These port folios are subject to minimum asset levels and strict eligibility guidelines to ensure ready access to cash in emergencies.
Risk control
We monitor and manage our liquidity position on a consolidated basis and consider legal, regulatory, tax, operational and any other applicable restrictions when analyzing our ability to lend or borrow funds between branches, branches and subsidiaries, and subsidiaries.
Policies
Our principal liquidity and funding policies are reviewed and approved annually by senior management committees and the Board of Directors. These broad policies establish risk tolerance parameters and authorize senior management committees or Corporate Treasury to approve more detailed policies and limits related to specific measures, businesses and products. These policies and procedures govern management, measurement and reporting requirements and define approved liquidity and funding limits.
Authorities and limits
Targets for our structural liquidity position, based on both a “cash capital” metric and a “survivability horizon” measurement, are approved at least annually and monitored regularly.
     With respect to net short-term funding requirements, all limits are monitored regularly to ensure compliance. The prescribed treatment of cash flow assets and liabilities under varying conditions are reviewed periodically to determine if they remain valid or changes to assumptions and limits are required in light of internal and/or external developments. Global market volatility in the latter part of 2007 has prompted us to modify the liquidity treatment of certain asset classes to reflect our expectations that market liquidity for these products will be sporadic for some time. Some limits are in the process of being reviewed and possibly revised to take into consideration the results of updated stress tests that reflect lessons learned during this period of market volatility.
Reporting
Detailed reports on our principal short-term asset/liability mismatches are monitored on a daily basis to ensure compliance with the limits for overall group exposure and by major currency, branches, subsidiaries and geographic locations. As set out in our liquidity and funding management framework, any potential exceptions to established limits on net fund outflows or other rules, whether monitored on a daily, weekly, monthly or quarterly basis, are reported immediately to Corporate Treasury, which provides or arranges for approval after reviewing a remedial action plan.
Funding
Funding strategy
Diversification of funding sources is a crucial component of our overall liquidity management strategy. Diversification expands our funding flexibility while minimizing funding concentration and dependency and generally reducing financing costs. To that effect, we completed the first Canadian covered bond issuance in November 2007. Maintaining competitive credit ratings is also critical to cost-effective funding. Core funding, comprising capital, longer-term liabilities and a diversified pool of personal and, to a lesser extent, commercial deposits, is the foundation of our strong structural liquidity position.
Credit ratings
Our ability to access unsecured funding markets and to engage in certain collateralized business activities on a cost-effective basis is primarily dependent upon maintaining competitive credit ratings. Our credit ratings are largely determined by the quality of our earnings, the adequacy of our capital and the effectiveness of our risk management programs. We estimate, based on periodic reviews of ratings triggers embedded in our existing businesses and of our funding capacity sensitivity, that a minor downgrade would not materially influence our liability composition, funding access, collateral usage and associated costs. However, a series of downgrades could have adverse consequences for our funding capacity, collateral requirements and on the results of our operations.
 
Credit ratings   Table 55
             
    Short-term   Senior    
As at November 29, 2007 (1)   debt   long-term debt   Outlook
 
Moody’s Investors Service
  P-1   Aaa   stable
Standard & Poor’s
  A-1+   AA-   positive
Fitch Ratings
  F1+   AA   stable
DBRS
  R-1(high)   AA   stable
 
(1)   Credit ratings are not recommendations to purchase, sell or hold a financial obligation inasmuch as they do not comment on market price or suitability for a particular investor. Ratings are subject to revision or withdrawal at any time by the rating organization.
During the year, there were two positive developments with respect to our ratings. In the second quarter of 2007, Moody’s Investors Service upgraded our senior long-term debt rating to Aaa from Aa2 as a result of refinements made to their joint default analysis, and in the third quarter of 2007, Standard & Poor’s revised our rating outlook to positive from stable, citing among other points, a sound liquidity profile and a very robust liquidity management infrastructure. Our Fitch and DBRS
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ratings and outlooks remain unchanged from October 31, 2006. Our collective ratings continue to be the highest categories assigned by the respective agencies to a Canadian bank and these strong credit ratings support our ability to competitively access unsecured funding markets.
Deposit profile
The composition of our global deposit liabilities is summarized in Note 13 to our Consolidated Financial Statements. In 2007, personal deposits remained the key source of funding for our Canadian dollar balance sheet while most foreign currency deposits originated from unsecured, wholesale sources, including large corporate and institutional clients and foreign commercial and central banks.
     Our personal deposit franchise constitutes the principal source of constant funding while certain commercial and institutional client groups also maintain relational balances with low volatility profiles. Taken together, these clients represent a highly stable supply of core deposits in most conceivable environments as they typically are less responsive to market developments than transactional lenders and investors due to the impact of deposit insurance and extensive and, at times, exclusive relationships with us. Core deposits, consisting of our own statistically derived estimates of the highly stable portions of all of our relational personal, commercial and institutional balances (demand, notice and fixed-term) together with wholesale funds maturing beyond one year, increased during the year by about 2% to 56% of our total deposits. We encourage wholesale funding diversity and regularly review sources of short-term funds to ensure that they are well-diversified by provider, product, market and geographic origin. In addition, we maintain an ongoing presence in different funding markets, which allows us to constantly monitor market developments and trends in order to identify opportunities and risks and to take appropriate and timely actions.
     
Term funding sources   Table 56
                         
(C$ millions)   2007     2006     2005  
 
Long-term funding outstanding
   $ 51,540     $ 33,361     $ 24,004  
Total mortgage-backed
securities sold
     14,239       12,186       8,487  
Commercial mortgage-backed
securities sold
     2,405       1,914       1,237  
Credit card receivables financed
through notes issued by a
securitization special
purpose entity
     2,759       2,250       2,500  
 
Our long-term funding sources are managed to minimize cost by limiting concentration by geographic location, investor segment, instrument, currency and maturity profile. In addition, liquidity objectives, market conditions, interest rates, credit spreads and desired financial structure influence our long-term funding activities. We operate debt issuance programs in Canada, the U.S., Europe, Australia and Japan. Diversification into new markets and untapped investor segments is also constantly evaluated against relative issuance costs.
     During 2007, we continued to expand our long-term funding base by issuing, either directly or through our subsidiaries, $30.7 billion of senior deposit notes in various currencies and markets. Total long-term funding outstanding increased $18.2 billion. Outstanding senior debt containing ratings triggers, which would accelerate repayment, constitutes a very small proportion of our overall outstanding debt.
Other liquidity and funding sources
We use commercial mortgage, residential mortgage and credit card receivable-backed securitization programs as alternative sources of funding and for liquidity and asset/liability management purposes. We hold retained interests in our residential mortgage and credit card securitization programs. Our total outstanding mortgage-backed securities sold increased year over year by $2.1 billion. Our credit card receivables, which are financed through notes issued by a securitization special purposes entity, increased year over year by $509 million. For further details, refer to the Off-balance sheet arrangements section and Note 5 to our Consolidated Financial Statements.
Impact of global market turmoil to our term funding capacity
Despite recent global market events, including a reduction in liquidity in term funding markets, our liquidity and funding position remains sound and adequate to execute our strategy. There are no known trends, demands, commitments or events that are presently expected to materially change this position.
     By leveraging our new and existing domestic and global funding programs, we continued to raise wholesale term funding in size during the latter half of 2007. Most of the funding was raised through large benchmark-sized transactions, but a significant amount was also raised in a variety of lower-cost funding transactions. In 2007, we raised wholesale term funding in 12 different currencies, including six currencies in the fourth quarter. The market turmoil did not prevent us from launching the first Canadian covered bond program, where we sold €2 billion of notes in the inaugural transaction, which settled on November 5, 2007. Our ability to raise wholesale term funding continued to significantly exceed our funding needs during the latter half of 2007.
Contractual obligations
In the normal course of business, we enter into contracts that give rise to commitments of future minimum payments that affect our liquidity. Depending on the nature of these commitments, the obligation may be recorded on- or off-balance sheet. The table below provides a summary of our future contractual funding commitments.
     
Contractual obligations   Table 57
                                                         
    2007     2006     2005  
(C$ millions) (1)   Within 1 year     1 to 3 years     Over 3 to 5 years     Over 5 years     Total     Total     Total  
 
Unsecured long-term funding
   $ 16,892     $ 16,350     $ 13,628     $ 4,670     $ 51,540     $ 33,361     $ 24,004  
Subordinated debentures
     —       118       —       6,117       6,235       7,103       8,167  
Obligations under leases (2)
     494       835       608       1,224       3,161       2,486       2,508  
 
 
   $ 17,386     $ 17,303     $ 14,236     $ 12,011     $ 60,936     $ 42,950     $ 34,679  
 
(1)   Amounts represent principal only and exclude accrued interest.
 
(2)   Substantially all of our lease commitments are operating.
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98   Management’s Discussion and Analysis  

 

 

REPUTATION RISK
     Reputation risk is the risk that an activity undertaken by an organization or its representatives will impair its image in the community or lower public confidence in it, resulting in the loss of business, legal action or increased regulatory oversight.
     Reputation risk can arise from a number of events and primarily occurs in connection with regulatory, legal and operational risks. Operational failures and non-compliance with laws and regulations can have a significant reputational impact on us.
     In addition to the six risk management principles discussed earlier in the Risk management overview section, the following principles also apply to our overall management of reputation risk:
•   We must operate with integrity at all times in order to sustain a strong and positive reputation
•   Protecting our reputation is the responsibility of all our employees, including senior management, and extends to all members of the Board of Directors.
Code of Conduct
Our corporate values and Code of Conduct underpin the management of risk to our reputation and drive our ethical culture. Our Code of Conduct is the foundation of employee and director awareness of the kinds of conduct that protect our reputation, and those that put our reputation at risk.
Responsibilities
The management of reputation risk is overseen by the Board of Directors. The key senior management committees involved with monitoring and reporting on reputation risk at an enterprise level are: Ethics and Compliance Committee, Policy Review Committee, Structured Transactions Oversight Committee and the Group Risk Committee.
Risk control
Policies
Policies and procedures support the management of reputation risk across the organization. Business segments have specific policies in place to manage the risks within their businesses, including reputation risk. A comprehensive set of policy requirements applies to the identification and assessment of reputation risk, including Know Your Client due diligence controls and procedures, anti-money laundering and anti-terrorist financing policy requirements, auditor independence requirements, research standards, whistle blowing, and the requirements for managing conflicts of interest.
Reporting
The responsibility for monitoring and reporting on reputation risk issues is primarily within GRM. Regular comprehensive reporting is provided to the Group Risk Committee and the Board of Directors and its committees. This includes annual reporting on fraud issues, litigation issues and quarterly reporting on regulatory, compliance and operational risk issues. Reputation risk issues are also raised in internal audit reports provided to senior management, summaries of which are provided to the Audit Committee.
REGULATORY AND LEGAL RISK
Regulatory and legal risk is the risk of negative impact to business activities, earnings or capital, regulatory relationships or reputation as a result of failure to comply with or a failure to adapt to current and changing regulations, law, industry codes or rules, regulatory expectations or ethical standards.
     Global Compliance, which is a part of Group Risk Management (GRM) has developed a comprehensive enterprise compliance management (ECM) framework that is consistent with regulatory guidance from the OSFI and other regulators. The framework is designed to promote the proactive, risk-based management of regulatory risk. It applies to all of our businesses and operations, legal entities and employees globally and confirms the shared accountability of all employees across the organization for ensuring we maintain robust and effective regulatory risk and compliance controls. The framework covers the following eight elements of compliance management: liaison with regulators, risk identification and assessment, control design and evaluation, learning and awareness, compliance execution, monitoring and oversight, issue management and reporting, and new initiative management.
Responsibilities
Global Compliance sets out the enterprise-wide requirements for the identification, assessment, control, monitoring and reporting of regulatory and compliance risk (and associated operational and reputation risk), as well as remediation of any issues identified. Oversight is provided by the Board of Directors through the CR&RPC and the Audit Committee. The Ethics and Compliance Committee supports our management of regulatory risk. It approves compliance programs and compliance-related policies and informs and advises the Group Risk Committee (GRC), CR&RPC and the Audit Committee on significant regulatory issues and remedial measures.
     The Chief Compliance Officer (CCO) and Global Compliance work closely with business partners to ensure the overall effectiveness of compliance and regulatory risk management controls across the enterprise through the ECM framework, which includes policies for consistent and effective compliance, independent oversight of compliance controls, timely reporting of trends and escalation of issues to senior management and the Board of Directors and timely execution of appropriate action plans.
Risk measurement
The identification and assessment of regulatory risk includes formal risk assessment activities carried out across the organization, both at the individual business and operational level, and at the enterprise level. Risk is measured through the assessment of the impact of regulatory and organizational changes, the introduction of new products and services, and the acquisition or development of new lines of business. It is also measured through the testing of the effectiveness of the controls established to ensure compliance with regulatory requirements and expectations. Although the use of metrics to measure compliance-related matters is relatively new and there are few proven methods for detecting leading indicators, we are working to develop such metrics. Meanwhile, we use what measures are available to identify issues and trends.
Risk control
Policies
We have a strong ethical and compliance culture grounded in our Code of Conduct. The Code of Conduct is regularly reviewed and updated to ensure that it continues to meet the expectations of regulators and other stakeholders. All our employees must reconfirm their understanding of and commitment to comply with the Code of Conduct at least every two years, and employees in certain key roles, such as Group Executive and others in financial oversight roles as identified in our Auditor Independence Policy, must do so annually.
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Management’s Discussion and Analysis  99

 

 

     We provide online and face-to-face training for all our employees in the area of anti-money laundering compliance and training in other compliance and regulatory risk related matters for relevant employees through other online tools and other job aids, as part of employees’ regular job training, in new employee orientation materials, and periodically through targeted face-to-face or webcast training.
Reporting
On a quarterly basis, the CCO reports compliance matters to senior management, management committees, the Audit Committee and CR&RPC. In addition, the CCO provides an annual report on overall compliance, and on specific topics, such as related party transactions, conflicts of interest, and compliance with Canadian consumer protection requirements, and the Global Chief Anti-Money Laundering Officer reports at least annually on anti-money laundering and anti-terrorist financing compliance. Similarly, senior compliance officers of our operating subsidiaries provide relevant annual and quarterly reports to their respective senior management and Boards of Directors.
ENVIRONMENTAL RISK
Environmental risk is the risk of loss to financial, operational or reputation value resulting from the impact of environmental issues. Environmental risk arises from our business activities and our operations. For example, the environmental issues associated with our clients’ purchase and sale of contaminated property or development of large-scale projects may give rise to credit and reputation risk for us. Operational and legal risks may arise when we are faced with environmental issues at our branches, offices or data processing centres.
     We undertake independent and collaborative research to identify and better understand the material environmental risks we face. Some current and emerging issues include climate change, biodiversity, water and the rights of indigenous peoples, among others.
Responsibilities
Environmental risk management activities are managed by the Corporate Environmental Affairs Group (CEA) with support from our business segments and Corporate Support groups. The CEA is responsible for developing and implementing the environmental risk management system, including identifying environmental risks in the organization, designing and supporting environmental risk policies, programs and initiatives, monitoring implementation, and leading communication and training. The CEA also provides advisory services and support to business and functional units on the management of specific environmental risks.
Risk measurement
Some environmental risks associated with our business and operational activities can be easily quantified while others are assessed on a qualitative basis. For example, in our lending activities, we quantify the potential cost of cleaning up environmental contamination of properties used as security for loans, and the cost to an obligor of making operational changes that may be required to meet environmental regulatory requirements or satisfy other obligations. In our own operations, we quantify our cost to maintain compliance with environmental regulations or applicable standards. Other environmental risks are assessed on a qualitative basis, for example, the exposure of a particular industry to the effects of climate change and climate change regulations. As environmental risk measurement methodologies mature, particularly with respect to climate change, we will incorporate more quantitative risk measures into our processes.
Risk control
We manage environmental risk by maintaining an environmental management system, including policy requirements, management and mitigation strategies, and reporting. Specifically, to manage environmental risk, we:
•   Develop and maintain environmental policies, standards, procedures and guidelines
•   Monitor relevant laws and regulations, as well as other requirements to which the bank adheres
•   Maintain environmental programs and initiatives
•   Establish roles and responsibilities for environmental management in the organization
•   Train employees to identify and manage environmental risks
•   Maintain an open dialogue with stakeholders, both internal and external to the organization
•   Measure our performance and compare it to our objectives, which enables us to identify enhancement opportunities
•   Periodically verify that our environmental risk management policies and processes are operating as intended.
Policies
Our Environmental Blueprint, launched in October 2007, updates our corporate environmental policy. It details environmental issues that are important to our stakeholders and us and outlines our commitment to reducing our environmental footprint, responsible lending and investment, and business growth and development of environmental products and services.
     Our suite of environmental credit risk management policies enables us to proactively identify and manage environmental risks in our lending activities. These policies are regularly reviewed to ensure compliance with legal and operational requirements, and to take into account evolving business activities.
     In addition to general policies for commercial and corporate lending, we have sector-specific and business-segment-specific policies and guidelines. For example, we have a separate Policy on Social and Environmental Review in our Project Finance business, which reflects our commitment to the Equator Principles (EPs). The EPs, which were revised in 2007, are voluntary guidelines that help financial institutions address the environmental and social risks associated with project finance.
Management and mitigation
In addition to adherence to policies, standards, procedures and guidelines, environmental risk is mitigated through transaction structuring and the use of insurance as well as other mechanisms. The CEA supports lenders, risk managers and clients in the management and mitigation of environmental risks in transactions, by recommending strategies to treat, eliminate or transfer (via insurance) environmental risk.
Reporting
The Board of Directors and senior management committees are periodically provided with reports and analysis on risks associated with environmental issues (for example, climate change and the Kyoto Accord, and the EPs), as appropriate. Loan losses resulting from environmental issues are tracked and reported to senior management.
     We report on our implementation of the EPs annually in our Corporate Responsibility Report and Public Accountability Statement (CRR & PAS) and on rbc.com. The CRR & PAS also provides information about our environmental policies, lending, emerging issues, stakeholder engagement, and environmental performance and initiatives.
Royal Bank of Canada: Annual Report 2007
100   Management’s Discussion and Analysis

 

 

INSURANCE RISK
Insurance risk is the risk of loss that may occur when actuarial assumptions made in insurance product design and pricing activities differ from actual experience. Insurance risk arises from our life and health, creditor, home and auto, and travel insurance, and reinsurance businesses. Insurance risk can be categorized into the following sub-risks:
•   Claims risk: The risk that the actual severity and/or frequency of claims differ from the levels assumed in pricing calculations. This risk can occur through (i) a misestimation of expected claims activities as compared to actual claims activities, or (ii) the misselection of a risk during the underwriting process
•   Policyholder behaviour risk: The risk that the behaviour of policy-holders relating to premium payments, policy withdrawals or loans, policy lapses, surrenders and other voluntary terminations differs from the behaviour assumed in pricing calculations
•   Expense risk: The risk that the expense of acquiring or administering policies, or of processing claims, exceeds the costs assumed in pricing calculations.
Responsibilities
Insurance risk approval authorities are established by the Board of Directors upon recommendation of its committees and delegated to senior management.
     The respective boards of directors of the insurance subsidiaries are responsible for the stewardship of the insurance companies. These boards of directors oversee and monitor the management of the insurance subsidiaries and ensure that the subsidiaries are properly managed and functioning within our overall strategies and policies.
     Group Risk Management (GRM) is responsible for providing risk management direction and oversight to the insurance businesses and for providing comprehensive reporting of insurance risks facing the organization. The Appointed Actuaries of our Canadian insurance subsidiaries are appointed by the boards of directors and have statutory requirements to provide opinions on adequacy of liabilities, sufficiency of capital, the insurance company’s future financial condition and fairness of treatment for policyholders. External actuarial reviewers, in accordance with the OSFI guidelines and Canadian Institute of Actuaries standards, provide oversight on the work of the Appointed Actuaries. Our international insurance subsidiaries receive similar actuarial oversight. Global Functions and Global Technology and Operations (GTO) also provide direction and oversight to manage risk within their areas of expertise.
     Insurance business units are responsible for the active management of insurance risk in partnership with GRM, other Global Functions groups and GTO.
Risk measurement
We measure insurance risks at regular intervals to ensure that our risk profile is appropriately monitored, reported, and aligned with business assumptions. These risk measurements are used for Economic Capital quantification, valuation of actuarial liabilities, and to meet statutory reporting requirements. This process is managed by GRM through the use of models.
     Models used for risk measurement are subject to a robust and systematic process of review and reporting in accordance with our Model Risk Policy. Key elements of the policy include maintaining appropriate model documentation, an approval process to ensure appropriate segregation of duties, independent and periodic model reviews, and clear accountability and oversight.
Risk control
Policies
Insurance risk policies articulate our strategies to identify, prioritize and manage insurance risk. GRM is responsible for insurance risk policies which establish the expectations and parameters within which the insurance businesses may operate, communicate our risk tolerance, and ensure accountability through clear roles and responsibilities.
Authorities and limits
Risk approval authorities and limits are established by the Board of Directors and delegated to management within the business units in order to guide insurance business activities. These delegated authorities and limits ensure our insurance portfolio is well diversified and within the risk appetite as approved by the Board of Directors.
Risk oversight and approval
GRM provides independent oversight over our insurance business activities including product development, product pricing, underwriting and claims management. GRM also approves authority for activities, which exceed business unit authorities and limits, and certain business activities, which are deemed to be of significant risk.
Risk mitigation
Our key elements for identifying, assessing and managing insurance risk include a risk-based approach for product development and pricing, effective guidelines and practices for underwriting and claims management. In addition, transferring insurance risk to independent insurance companies or reinsurance is used to diversify our portfolio of insurance risks, limit loss exposure to large risks, and provide additional capacity for future growth.
Actuarial liabilities
Actuarial liabilities are estimates of the amounts required to meet obligations resulting from insurance contracts. Liabilities for estimated future policy benefits and expenses are established in accordance with the standards of practice of the Canadian Institute of Actuaries and the requirements of the OSFI and other relevant professional and regulatory bodies. Actuarial liabilities under Canadian GAAP are calculated using the Canadian Asset Liability Method. These estimates and actuarial assumptions include explicit provisions for adverse deviations to ensure adequacy of liabilities and are validated through extensive internal and independent external reviews and audits.
Reporting
GRM regularly provides independent evaluation and reporting on our insurance risk exposures to management at the business segment level and at the enterprise level. The reports analyze and communicate insurance risk information and contribute to the overall understanding of insurance risk. Reporting includes an assessment of risks facing the insurance business units, trends related to all claims and adequacy of actuarial liabilities. The reports also provide an assessment of the risk-return profile of insurance products and a view of future potential risks.
STRATEGIC RISK
Strategic risk is the risk that an enterprise or a particular business area makes inappropriate strategic choices, or is unable to successfully implement selected strategies or related plans and decisions.
We apply the following principles to manage strategic risk:
•   Significant decisions are aligned with our enterprise strategy
 
•   Business segment strategy is aligned with our enterprise strategy
 
•   All business strategies are supported by market and competitive analysis and financial projection of their expected impact.
The effective identification and assessment of this risk is critical for us and involves the Group Executive and the Board of Directors when identifying and assessing various strategic opportunities for the organization.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  101

 

 

Responsibilities
Responsibility for successfully implementing strategies is mandated to the individual heads of the businesses. The Strategy and Development team within Global Functions is responsible for the articulation of our enterprise strategy. This team also provides support for the development of strategies of the business segments and lines of business. The identification and analysis of strategic issues, opportunities and risks we face is an ongoing component of their overall responsibilities.
Risk control
The project appropriation request (PAR) process is used to manage strategic risk. Our strategic initiatives group provides an initial review and co-ordinates circulating each PAR to GRM, Law and Corporate Treasury for review, comments and approval. The Board of Directors and/or Group Risk Committee may approve the finalized version if their approval is warranted. PARs are a critical part of our corporate governance framework and are available for review by regulators or our external auditors as required.
COMPETITIVE RISK
Competitive risk is the risk associated with the inability to build or maintain sustainable competitive advantage in a given market or markets. This risk can arise within or outside the financial sector, from traditional or non-traditional competitors, domestically or globally.
     We manage competitive risk through appropriate identification and assessment as part of our overall risk management process. This includes risk assessment of new or enhanced products and services, alliances and acquisitions. Our ability to adapt to a changing competitive environment will impact our overall financial performance.
SYSTEMIC RISK
Systemic risk is the risk that the financial system as a whole may not withstand the effects of a crisis resulting from extraordinary economic, political, social or financial circumstances. This could result in financial, reputation or other losses.
Systemic risk is considered to be the least controllable risk we face. Our ability to mitigate this risk when undertaking business activities is very limited, other than through collaborative mechanisms between industry participants, and, as appropriate, the public sector, to reduce the frequency and impact of these risks.
ADDITIONAL RISKS THAT MAY AFFECT FUTURE RESULTS
By their very nature, forward-looking statements, including those made in this document, require us to make assumptions and are subject to inherent risks and uncertainties which may cause our actual results to differ materially from our expectations expressed in such forward-looking statements. Factors that might cause our actual financial performance to vary from that described in our forward-looking statements include credit, market, operational, liquidity and funding risks, and other risks discussed in detail in the Risk management section. In addition, the following discussion sets forth other factors we believe could cause our actual results to differ materially from expected results.
Industry factors
General business and economic conditions in Canada, the United States and other countries in which we conduct business Interest rates, foreign exchange rates, the stability of various financial markets, including the impact from the continuing volatility in the U.S. subprime and related markets and lack of liquidity in various other financial markets, consumer spending, business investment, government spending, the level of activity and volatility of the capital markets, inflation and terrorism each impact the business and economic environments in which we operate and, ultimately, the level of business activity we conduct and earnings we generate in a specific geographic region. For example, an economic downturn in a country may result in high unemployment and lower family income, corporate earnings, business investment and consumer spending, and could adversely affect the demand for our loan and other products. In addition, our provision for credit losses would likely increase, resulting in lower earnings. Similarly, a downturn in a particular equity or debt market could cause a reduction in new issue and investor trading activity or assets under management and assets under administration, resulting in lower fee, commission and other revenue. Also, defaults by a large financial institution in Canada, the United States or internationally could adversely affect the financial markets generally and us specifically.
Currency rates
Our revenue, expenses and income denominated in currencies other than the Canadian dollar are subject to fluctuations in the movement of the Canadian dollar relative to those currencies. Such fluctuations may affect our overall business and financial results. Our most significant exposure is to the U.S. dollar due to our level of operations in the U.S., and other activities conducted in U.S. dollars. The strengthening of the Canadian dollar compared to the U.S. dollar over the last four years has had a significant effect on our results. We are also exposed to the British pound and the Euro due to our activities conducted internationally in these currencies. Further appreciation of the Canadian dollar relative to the U.S. dollar, British pound and Euro reduced the translated value of U.S. dollar-, British pound- and Euro-denominated revenue, expenses and earnings.
Government monetary and other policies
Our businesses and earnings are affected by the monetary policies that are adopted by the Bank of Canada and the Board of Governors of the Federal Reserve System in the United States, as well as those adopted by international agencies, in jurisdictions in which we operate. For example, monetary policy decisions by the Bank of Canada have an impact on the level of interest rates, fluctuations of which can have an impact on our earnings. As well, such policies can adversely affect our clients and counterparties in Canada, the United States and internationally, which may increase the risk of default by such clients and counterparties. Our businesses and earnings are also affected by fiscal or other policies that are adopted by various regulatory authorities in Canada, the United States and international agencies.
Royal Bank of Canada: Annual Report 2007
102  Management’s Discussion and Analysis

 

 

Level of competition
The competition for clients among financial services companies in the consumer and business markets in which we operate is intense. Client loyalty and retention can be influenced by a number of factors, including relative service levels, the prices and attributes of our products or services, our reputation and actions taken by our competitors. Other financial companies, such as insurance and mono-line companies and non-financial companies are increasingly offering services traditionally provided by banks. Such competition could also reduce fee revenue and adversely affect our earnings.
Changes in laws and regulations
Laws and regulations are in place to protect the financial and other interests of our clients, investors and the public interest. Changes to laws, including tax laws, regulations or regulatory policies, including changes to our capital management framework, as well as changes in how they are interpreted, implemented or enforced, could adversely affect us, for example, by lowering barriers to entry in the businesses in which we operate or increasing our costs of compliance. In addition, our failure to comply with applicable laws, regulations or regulatory policies could result in sanctions and financial penalties by regulatory agencies that could adversely impact our reputation and earnings.
Judicial or regulatory judgments and legal proceedings
Although we take what we believe to be reasonable measures designed to ensure compliance with laws, regulations and regulatory policies in the jurisdictions in which we conduct business, there is no assurance that we always will be, or will be deemed to be, in compliance. Accordingly, it is possible that we could receive a judicial or regulatory judgment or decision that results in fines, damages and other costs that would damage our reputation and negatively impact on our earnings.
     We are also subject to litigation arising in the ordinary course of our business. The adverse resolution of any litigation could have a material adverse effect on our results or could give rise to significant reputational damage, which could impact our future business prospects.
Accuracy and completeness of information on clients and counterparties
When deciding to extend credit or enter into other transactions with clients and counterparties, we may rely on information provided by or on behalf of clients and counterparties, including audited financial statements and other financial information. We also may rely on representations of clients and counterparties as to the completeness and accuracy of that information. Our financial results could be adversely impacted if the financial statements and other financial information relating to clients and counterparties on which we rely do not comply with GAAP or are materially misleading.
Bank specific factors
Execution of our strategy
Our ability to execute on our objectives and strategic goals will influence our financial performance. If our strategic goals do not meet with success or there is a change in our strategic goals, our financial results could be adversely affected.
Acquisitions and joint ventures
Although we regularly explore opportunities for strategic acquisitions of, or joint ventures with, companies in our lines of businesses, there is no assurance that we will receive required regulatory or shareholder approvals or be able to complete acquisitions or joint ventures on terms and conditions that satisfy our investment criteria. There is also no assurance we will achieve our financial or strategic objectives or anticipated cost savings following acquisitions or forming joint ventures. Our performance is contingent on retaining the clients and key employees of acquired companies and joint ventures, and there is no assurance that we will always succeed in doing so.
Changes in accounting standards, accounting policies and estimates
From time to time, the Accounting Standards Board of the CICA changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be difficult to anticipate and can materially impact how we record and report our financial condition and results of operations. In some instances, we may be required to retroactively apply a new or revised standard that results in our restating prior period financial statements.
     The accounting policies and methods we utilize determine how we report our financial condition and results of operations, and they require management to make estimates or rely on assumptions about matters that are inherently uncertain. Such estimates and assumptions may require revisions, and changes to them may materially adversely affect our results of operations and financial condition. Significant accounting policies are described in Note 1 to our Consolidated Financial Statements.
     As detailed in the Critical accounting policies and estimates section, we have identified seven accounting policies as being “critical” to the presentation of our financial condition and results of operations as they; (i) require management to make particularly subjective and/or complex judgments about matters that are inherently uncertain; and (ii) carry the likelihood that materially different amounts could be reported under different conditions or using different assumptions and estimates.
Ability to attract employees and executives
Competition for qualified employees and executives is intense both within the financial services industry and from non-financial industries looking to recruit. If we are unable to retain and attract qualified employees and executives, our results of operations and financial condition, including our competitive position, may be materially adversely affected.
Changes to our credit ratings
There can be no assurance that our credit ratings and rating outlooks from rating agencies such as Moody’s Investors Service, Standard & Poor’s, Fitch Ratings or DBRS will not be lowered or that these ratings agencies will not issue adverse commentaries about us, potentially resulting in higher financing costs and reduced access to capital markets. A lowering of our credit ratings may also affect our ability, and the cost, to enter into normal course derivative or hedging transactions.
Development and integration of our distribution networks
Although we regularly explore opportunities to expand our distribution networks, either through acquisitions or organically by adding, for example, new bank branches, insurance offices, online savings accounts and ATMs in high-growth markets in Canada, the United States and internationally, if we are not able to develop or integrate these distribution networks effectively, our results of operations and financial condition may be negatively affected.
Other factors
Other factors that may affect actual results include changes in government trade policy, the timely and successful development of new products and services, technological changes and our reliance on third parties to provide components of our business infrastructure, fraud by internal or external parties, unexpected changes in consumer spending and saving habits, the possible impact on our business from disease or illness that affects local, national or global economies, disruptions to public infrastructure, including transportation, communication, power and water, international conflicts and other political developments including those relating to the war on terrorism, and our success in anticipating and managing the associated risks.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  103

 

 

     We caution that the foregoing discussion of risk factors is not exhaustive and other factors could also adversely affect our results. When relying on our forward-looking statements to make decisions with respect to us, investors and others should carefully consider the foregoing factors, other uncertainties and potential events, and other industry- and bank-specific factors that may adversely affect our future results and the market valuation placed on our common shares. Unless required by law, we do not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by us or on our behalf.
ADDITIONAL FINANCIAL INFORMATION
     
Net interest income on average assets and liabilities from continuing operations (1)   Table 58
                                                                         
    Average balances (2)     Interest (3)     Average rate  
(C$ millions, except percentage amounts)   2007     2006     2005     2007     2006     2005     2007     2006     2005  
 
Assets
                                                                        
Deposits with other banks
                                                                        
Canada
   $ 1,570     $ 1,218     $ 915     $ 43     $ 41     $ 31       2.74 %     3.37 %     3.39 %
United States
     2,904       1,856       1,587       176       155       55       6.06       8.35       3.47  
Other International
     5,436       4,913       4,068       319       284       145       5.87       5.78       3.56  
 
 
     9,910       7,987       6,570       538       480       231       5.43       6.01       3.52  
 
Securities
                                                                        
Trading
     162,828       134,166       110,356       6,621       5,056       3,711       4.07       3.77       3.36  
Available-for-sale (4)
     31,516       —       —       1,044       —       —       3.31       —       —  
Investments (4)
     —       38,792       37,876       —       1,133       895       —       2.92       2.36  
 
 
     194,344       172,958       148,232       7,665       6,189       4,606       3.94       3.58       3.11  
 
Asset purchased under reverse repurchase agreements and securities borrowed
     71,759       55,615       44,420       3,450       2,827       1,354       4.81       5.08       3.05  
Loans (5)
                                                                        
Canada
                                                                        
Retail
     152,588       135,852       124,001       9,376       8,157       7,037       6.14       6.00       5.67  
Wholesale
     31,541       31,539       28,087       1,047       1,264       1,262       3.32       4.01       4.49  
 
 
     184,129       167,391       152,088       10,423       9,421       8,299       5.66       5.63       5.46  
United States
     25,718       21,871       20,572       2,240       2,110       1,626       8.71       9.65       7.90  
Other International
     13,388       8,286       6,993       2,061       1,177       865       15.39       14.20       12.37  
 
 
     223,235       197,548       179,653       14,724       12,708       10,790       6.60       6.43       6.01  
 
Total interest-earning assets
     499,248       434,108       378,875       26,377       22,204       16,981       5.28       5.11       4.48  
Non-interest-bearing deposits with other banks
     2,137       2,806       2,567       —       —       —       —       —       —  
Customers’ liability under acceptances
     10,270       8,748       6,411       —       —       —       —       —       —  
Other assets
     69,345       56,438       57,447       —       —       —       —       —       —  
 
Total assets
   $ 581,000     $ 502,100     $ 445,300     $ 26,377     $ 22,204     $ 16,981       4.54 %     4.42 %     3.81 %
 
Liabilities and shareholders’ equity
                                                                        
Deposits (6)
                                                                        
Canada
   $ 166,983     $ 167,015     $ 161,866     $ 5,669     $ 5,024     $ 3,724       3.39 %     3.01 %     2.30 %
United States
     53,817       47,913       40,004       2,563       2,018       1,047       4.76       4.21       2.62  
Other International
     121,924       91,334       70,168       5,538       3,666       2,175       4.54       4.01       3.10  
 
 
     342,724       306,262       272,038       13,770       10,708       6,946       4.02       3.50       2.55  
 
Obligations related to securities sold short
     46,654       38,630       34,169       1,997       2,071       1,381       4.28       5.36       4.04  
Obligations related to assets sold under repurchase agreements and securities loaned
     42,503       32,786       25,912       2,364       1,882       1,120       5.56       5.74       4.32  
Subordinated debentures
     6,704       8,013       8,359       338       419       442       5.04       5.23       5.29  
Other interest-bearing liabilities
     3,569       2,759       4,041       376       328       299       10.54       11.89       7.40  
 
Total interest-bearing liabilities
     442,154       388,450       344,519       18,845       15,408       10,188       4.26       3.97       2.96  
Non-interest-bearing deposits
     25,752       17,037       16,159       —       —       —       —       —       —  
Acceptances
     10,270       8,882       6,414       —       —       —       —       —       —  
Other liabilities
     79,087       66,755       58,757       —       —       —       —       —       —  
 
Total liabilities
   $ 557,263     $ 481,124     $ 425,849     $ 18,845     $ 15,408     $ 10,188       3.38 %     3.20 %     2.39 %
 
Shareholders’ equity
                                                                        
Preferred
   $ 1,553     $ 1,022     $ 811     $ —     $ —     $ —       — %     — %     — %
Common
     22,184       19,954       18,640       —       —       —       —       —       —  
 
Total liabilities and shareholders’ equity
   $ 581,000     $ 502,100     $ 445,300     $ 18,845     $ 15,408     $ 10,188       3.24 %     3.07 %     2.29 %
 
Net interest income and margin
   $ 581,000     $ 502,100     $ 445,300     $ 7,532     $ 6,796     $ 6,793       1.30 %     1.35 %     1.53 %
 
Net interest income and margin (average earning assets)(7)
                                                                        
Canada
   $ 280,385     $ 257,319     $ 229,184     $ 6,435     $ 6,045     $ 5,628       2.30 %     2.35 %     2.46 %
United States
     106,044       90,684       74,842       412       108       608       .39       .12       .81  
Other International
     112,819       86,105       74,849       685       643       557       .61       .75       .74  
 
Total
   $ 499,248     $ 434,108     $ 378,875     $ 7,532     $ 6,796     $ 6,793       1.51 %     1.57 %     1.79 %
 
(1)   Geographic classification for selected assets and liabilities is based on the domicile of the booking point of the subject assets and liabilities.
 
(2)   Calculated using methods intended to approximate the average of the daily balances for the period.
 
(3)   Interest income includes loan fees of $331 million (2006 — $348 million; 2005 — $343 million).
 
(4)   Available-for-sale securities are carried at fair value. Prior to November 1, 2006, Available-for-sale securities were classified as investment securities and were carried at amortized cost.
 
(5)   Average balances include impaired loans.
 
(6)   Deposits include savings deposits with average balances of $46 billion (2006 — $46 billion; 2005 — $46 billion), interest expense of $.4 billion (2006 — $.4 billion; 2005 — $.3 billion) and average rates of .9% (2006 — .8%; 2005 — .6%). Deposits also include term deposits with average balances of $240 billion (2006 — $206 billion; 2005 — $181 billion), interest expense of $10.7 billion (2006 — $8.3 billion; 2005 — $5.3 billion) and average rates of 4.43% (2006 — 4.02%; 2005 — 2.95%).
 
(7)   During the year, we reviewed the geographic information that was used to prepare the Net interest income and margin for the prior periods and determined that some information was incorrectly classified; accordingly, the Net interest income and margins presented for the comparative periods have been revised.
Royal Bank of Canada: Annual Report 2007
104  Management’s Discussion and Analysis

 

 

     
Loans and acceptances by geography (1)   Table 59
                                         
    As at October 31  
(C$ millions)   2007     2006     2005     2004     2003  
 
Canada
                                        
Residential mortgages
   $ 107,453     $ 94,272     $ 88,808     $ 80,168     $ 73,978  
Personal
     42,506       37,946       33,986       30,415       26,445  
Credit cards
     8,142       6,966       6,024       6,298       4,663  
Small business (2)
     2,652       2,318       1,951       1,928       1,335  
 
Retail
     160,753       141,502       130,769       118,809       106,421  
 
Business (3)
     51,237       44,353       42,383       35,214       34,551  
Sovereign (4)
     585       553       521       535       572  
Bank
     3,235       2,031       74       106       118  
 
Wholesale
     55,057       46,937       42,978       35,855       35,241  
 
 
   $ 215,810     $ 188,439     $ 173,747     $ 154,664     $ 141,662  
 
United States
                                        
Retail
     6,804       7,652       7,741       7,010       6,189  
Wholesale
     18,548       13,847       12,317       11,698       13,213  
 
 
     25,352       21,499       20,058       18,708       19,402  
 
Other International
                                        
Retail
     1,905       1,896       1,729       1,411       1,517  
Wholesale
     8,148       7,213       3,454       3,961       5,811  
 
 
     10,053       9,109       5,183       5,372       7,328  
 
Total loans and acceptances
   $ 251,215     $ 219,047     $ 198,988     $ 178,744     $ 168,392  
 
Total allowance for loan losses
     (1,493 )     (1,409 )     (1,498 )     (1,644 )     (2,055 )
 
Total loans and acceptances, net of allowance for loan losses
   $249,722   $ 217,638     $ 197,490     $ 177,100     $ 166,337  
 
(1)   Geographic information is based on residence of borrower.
 
(2)   Includes small business exposure managed on a pooled basis.
 
(3)   Includes small business exposure managed on an individual client basis.
 
(4)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  105

 

 

     
Impaired loans by portfolio and geography (1)   Table 60
                                         
    As at October 31  
(C$ millions, except percentage amounts)   2007     2006     2005     2004     2003  
 
Residential mortgages
   $ 210     $ 165     $ 146     $ 156     $ 138  
Personal
     189       205       183       204       255  
Small business (2)
     19       13       11       8       17  
 
Retail
   $ 418     $ 383     $ 340     $ 368     $ 410  
 
Business (3)
                                        
Agriculture
   $ 65     $ 45     $ 48     $ 89     $ 146  
Automotive
     5       8       4       8       12  
Consumer goods
     83       85       73       59       75  
Energy
     3       6       47       162       240  
Non-bank financial services
     14       15       15       14       45  
Forest products
     29       12       16       163       181  
Industrial products
     29       17       12       60       44  
Mining and metals
     4       5       4       10       57  
Real estate and related
     345       82       74       102       113  
Technology and media
     10       49       52       89       129  
Transportation and environment
     19       19       14       19       143  
Other
     116       108       75       116       150  
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ 722     $ 451     $ 434     $ 891     $ 1,335  
 
Total impaired loans (5), (6)
   $ 1,140     $ 834     $ 774     $ 1,259     $ 1,745  
 
Canada
                                        
Residential mortgages
   $ 149     $ 127     $ 106     $ 96     $ 110  
Personal
     152       183       161       178       213  
Small business (2)
     19       13       11       8       17  
 
Retail
   $ 320     $ 323     $ 278     $ 282     $ 340  
 
Business (3)
     377       266       225       501       724  
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ 377     $ 266     $ 225     $ 501     $ 724  
 
 
   $ 697     $ 589     $ 503     $ 783     $ 1,064  
 
United States
                                        
Retail
   $ 57     $ 15     $ 16     $ 44     $ 29  
Wholesale
     314       151       173       332       332  
 
 
   $ 371     $ 166     $ 189     $ 376     $ 361  
 
Other International
                                        
Retail
   $ 41     $ 45     $ 46     $ 42     $ 41  
Wholesale
     31       34       36       58       279  
 
 
   $ 72     $ 79     $ 82     $ 100     $ 320  
 
Total impaired loans
   $ 1,140     $ 834     $ 774     $ 1,259     $ 1,745  
 
Specific allowance for loan losses
     (351 )     (263 )     (282 )     (487 )     (757 )
 
Net impaired loans
   $ 789     $ 571     $ 492     $ 772     $ 988  
 
Gross impaired loans as a % of loans and acceptances:
                                        
Residential mortgages
     .19 %     .17 %     .16 %     .19 %     .18 %
Personal
     .39 %     .46 %     .45 %     .55 %     .79 %
Small business (2)
     .72 %     .56 %     .56 %     .41 %     1.27 %
 
Retail
     .25 %     .25 %     .24 %     .29 %     .36 %
Wholesale
     .88 %     .66 %     .74 %     1.73 %     2.46 %
 
Total
     .45 %     .38 %     .39 %     .70 %     1.04 %
 
Specific allowance for loan losses as a % of gross impaired loans
     30.79 %     31.53 %     36.43 %     38.68 %     43.38 %
 
(1)   Geographic information is based on residence of borrower.
 
(2)   Includes small business exposure managed on a pooled basis.
 
(3)   Includes small business exposure managed on an individual client basis.
 
(4)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
 
(5)   Includes foreclosed assets of $36 million in 2007 (2006 — $9 million; 2005 — $17 million; 2004 — $27 million; 2003 — $34 million).
 
(6)   Past due loans greater than 90 days not included in impaired loans were $353 million in 2007 (2006 — $305 million; 2005 — $304 million; 2004 — $219 million; 2003 — $222 million).
Royal Bank of Canada: Annual Report 2007
106  Management’s Discussion and Analysis

 

 

     
Provision for (recovery of) credit losses by portfolio and geography (1)   Table 61
                                         
    For the year ended October 31
(C$ millions, except percentage amounts)   2007     2006     2005     2004     2003  
 
Residential mortgages
   $ 13     $ 6     $ 2     $ 7     $ 8  
Personal
     364       306       259       222       254  
Credit cards
     223       163       194       167       155  
Small business (2)
     34       29       27       27       39  
 
Retail
   $ 634     $ 504     $ 482     $ 423     $ 456  
 
Business (3)
                                        
Agriculture
   $ 2     $ (1 )   $ (12 )   $ 7     $ —  
Automotive
     2       4       —       2       —  
Consumer goods
     27       7       24       (11 )     17  
Energy
     (7 )     (53 )     (20 )     50       78  
Non-bank financial services
     —       4       10       —       (1 )
Forest products
     10       2       (52 )     7       16  
Industrial products
     10       4       (7 )     13       5  
Mining and metals
     1       —       (1 )     (3 )     5  
Real estate and related
     70       1       (11 )     (1 )     (8 )
Technology and media
     (2 )     (5 )     (6 )     2       32  
Transportation and environment
     7       1       8       (32 )     79  
Other
     28       14       (26 )     64       42  
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ 148     $ (22 )   $ (93 )   $ 98     $ 265  
 
Total specific provision
   $ 782     $ 482     $ 389     $ 521     $ 721  
 
Canada
                                        
Residential mortgages
   $ 5     $ 6     $ 1     $ 6     $ 4  
Personal
     334       296       247       211       230  
Credit cards
     220       161       192       166       152  
Small business (2)
     34       29       27       27       39  
 
Retail
   $ 593     $ 492     $ 467     $ 410     $ 425  
 
Business (3)
     102       15       (32 )     3       102  
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ 102     $ 15     $ (32 )   $ 3     $ 102  
 
 
   $ 695     $ 507     $ 435     $ 413     $ 527  
 
United States
                                        
Retail
   $ 34     $ 12     $ 15     $ 13     $ 30  
Wholesale
     50       (38 )     (60 )     106       78  
 
 
   $ 84     $ (26 )   $ (45 )   $ 119     $ 108  
 
Other International
                                        
Retail
   $ 7     $ —     $ —     $ —     $ 1  
Wholesale
     (4 )     1       (1 )     (11 )     85  
 
 
   $ 3     $ 1     $ (1 )   $ (11 )   $ 86  
 
Total specific provision
   $ 782     $ 482     $ 389     $ 521     $ 721  
 
Total general provision
   $ 9     $ (53 )   $ 66     $ (175 )   $ —  
 
Total provision for credit losses
   $ 791     $ 429     $ 455     $ 346     $ 721  
 
Specific provision as a % of average net loans and acceptances
     .33 %     .23 %     .21 %     .30 %     .43 %
 
(1)   Geographic information is based on residence of borrower.
 
(2)   Includes small business exposure managed on a pooled basis.
 
(3)   Includes small business exposure managed on an individual client basis.
 
(4)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  107

 

 

     
Allowance for credit losses by portfolio and geography (1)   Table 62
                                         
(C$ millions, except percentage amounts)   2007     2006     2005     2004     2003  
 
Allowance at beginning of year
   $ 1,486     $ 1,568     $ 1,714     $ 2,164     $ 2,314  
Provision for credit losses
     791       429       455       346       721  
Write-offs by portfolio
                                        
Residential mortgages
     (5 )     (5 )     (5 )     (7 )     (10 )
Personal
     (444 )     (379 )     (353 )     (332 )     (379 )
Credit cards
     (268 )     (204 )     (237 )     (207 )     (192 )
Small business (2)
     (42 )     (36 )     (34 )     (44 )     (53 )
 
Retail
   $ (759 )   $ (624 )   $ (629 )   $ (590 )   $ (634 )
 
Business (3)
   $ (109 )   $ (89 )   $ (141 )   $ (411 )   $ (348 )
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ (109 )   $ (89 )   $ (141 )   $ (411 )   $ (348 )
 
Less developed countries exposures
   $ —     $ —     $ —     $ —     $ —  
 
Total write-offs by portfolio
   $ (868 )   $ (713 )   $ (770 )   $ (1,001 )   $ (982 )
 
Recoveries by portfolio
                                        
Residential mortgages
   $ 1     $ —     $ —     $ —     $ —  
Personal
     74       64       69       68       68  
Credit cards
     46       41       43       39       37  
Small business (2)
     7       7       9       11       12  
 
Retail
   $ 128     $ 112     $ 121     $ 118     $ 117  
 
Business (3)
   $ 42     $ 93     $ 53     $ 98     $ 53  
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ 42     $ 93     $ 53     $ 98     $ 53  
 
Total recoveries by portfolio
   $ 170     $ 205     $ 174     $ 216     $ 170  
 
Net write-offs
   $ (698 )   $ (508 )   $ (596 )   $ (785 )   $ (812 )
Adjustments (5)
     (7 )     (3 )     (5 )     (11 )     (59 )
 
Total allowance for credit losses at end of year
   $ 1,572     $ 1,486     $ 1,568     $ 1,714     $ 2,164  
 
Canada
                                        
Residential mortgages
   $ 13     $ 11     $ 9     $ 11     $ 12  
Personal
     79       88       101       108       129  
Small business (2)
     9       9       8       6       13  
 
Retail
   $ 101     $ 108     $ 118     $ 125     $ 154  
 
Business (3)
     153       112       112       202       284  
Sovereign (4)
     —       —       —       —       —  
Bank
     —       —       —       —       —  
 
Wholesale
   $ 153     $ 112     $ 112     $ 202     $ 284  
 
 
   $ 254     $ 220     $ 230     $ 327     $ 438  
 
United States
                                        
Retail
   $ 14     $ 3     $ 3     $ 5     $ 11  
Wholesale
     54       12       18       118       131  
 
 
   $ 68     $ 15     $ 21     $ 123     $ 142  
 
Other International
                                        
Retail
   $ 13     $ 12     $ 12     $ 14     $ 15  
Wholesale
     16       16       19       23       162  
 
 
   $ 29     $ 28     $ 31     $ 37     $ 177  
 
Total specific allowance for loan losses
   $ 351     $ 263     $ 282     $ 487     $ 757  
 
General allowance
   $ 1,221     $ 1,223     $ 1,286     $ 1,227     $ 1,407  
 
Total allowance for credit losses
   $ 1,572     $ 1,486     $ 1,568     $ 1,714     $ 2,164  
 
Key ratios
                                        
Allowance for credit losses as a % of loans and acceptances
     .63 %     .68 %     .79 %     .97 %     1.30 %
Net write-offs as a % of average net loans and acceptances
     .30 %     .25 %     .32 %     .46 %     .49 %
 
(1)   Geographic information is based on residence of borrower.
 
(2)   Includes small business exposure managed on a pooled basis.
 
(3)   Includes small business exposure managed on an individual client basis.
 
(4)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
 
(5)   Other adjustments include primarily foreign exchange translations on non-Canadian dollar denominated allowance for credit losses and acquisition adjustments for Flag Bank, $21 million in 2007; Provident Financial Group Inc., $6 million in 2004; Admiralty Bancorp, Inc., $8 million in 2003.
Royal Bank of Canada: Annual Report 2007
108  Management’s Discussion and Analysis

 

 

     
Credit quality information by Canadian province (1)   Table 63
     
                                         
(C$ millions)   2007     2006     2005     2004     2003  
 
Loans and acceptances
                                        
Atlantic provinces (2)
   $ 11,556     $ 10,256     $ 10,255     $ 9,598     $ 9,191  
Quebec
     35,168       32,723       26,646       23,670       22,564  
Ontario
     92,956       83,839       78,283       70,896       64,351  
Prairie provinces (3)
     40,956       32,598       31,190       26,701       24,084  
B.C. and territories (4)
     35,174       29,023       27,373       23,799       21,472  
 
Total loans and acceptances in Canada
   $ 215,810     $ 188,439     $ 173,747     $ 154,664     $ 141,662  
 
Gross impaired loans
                                        
Atlantic provinces (2)
   $ 53     $ 53     $ 47     $ 60     $ 81  
Quebec
     118       68       44       131       155  
Ontario
     322       286       269       254       348  
Prairie provinces (3)
     112       107       78       93       140  
B.C. and territories (4)
     92       75       65       245       340  
 
Total gross impaired loans in Canada
   $ 697     $ 589     $ 503     $ 783     $ 1,064  
 
Specific provision
                                        
Atlantic provinces (2)
   $ 40     $ 33     $ 30     $ 34     $ 46  
Quebec
     66       47       7       (1 )     77  
Ontario
     490       344       368       318       309  
Prairie provinces (3)
     51       38       44       31       55  
B.C. and territories (4)
     48       45       (14 )     31       40  
 
Total specific provision for credit losses in Canada
   $ 695     $ 507     $ 435     $ 413     $ 527  
 
(1)   Based on residence of borrower.
(2)   Comprises Newfoundland and Labrador, Prince Edward Island, Nova Scotia and New Brunswick.
(3)   Comprises Manitoba, Saskatchewan and Alberta.
(4)   Comprises British Columbia, Nunavut, Northwest Territories and Yukon.
     
Small business loans and acceptances in Canada by sector (1)   Table 64
                                         
    As at October 31  
(C$ millions)   2007     2006     2005     2004     2003  
 
Agriculture
   $ 271     $ 248     $ 715     $ 519     $ 70  
Automotive
     650       601       490       463       462  
Consumer goods
     2,350       2,043       1,728       1,764       1,777  
Energy
     370       284       182       150       137  
Non-bank financial services
     88       73       78       51       97  
Forest products
     351       366       311       276       298  
Industrial products
     1,543       1,377       1,057       999       952  
Mining and metals
     98       88       57       62       65  
Real estate and related
     2,822       2,565       1,982       1,821       1,777  
Technology and media
     314       300       243       232       242  
Transportation and environment
     901       774       549       502       503  
Other
     4,488       4,098       3,365       3,298       3,325  
 
Total small business loans
   $ 14,246     $ 12,817     $ 10,757     $ 10,137     $ 9,705  
 
(1)   Includes small business exposure managed on a pooled and individual client basis.
Royal Bank of Canada: Annual Report 2007
Management’s Discussion and Analysis  109

 

 

GLOSSARY
Acceptances
A bill of exchange or negotiable instrument drawn by the borrower for payment at maturity and accepted by a bank. The acceptance constitutes a guarantee of payment by the bank and can be traded in the money market. The bank earns a “stamping fee” for providing this guarantee.
Allowance for credit losses
The amount deemed adequate by management to absorb identified credit losses as well as losses that have been incurred but are not yet identifiable as at the balance sheet date. This allowance is established to cover the lending portfolio including loans, acceptances, guarantees, letters of credit and unfunded commitments. The allowance is increased by the provision for credit losses, which is charged to income and decreased by the amount of write-offs, net of recoveries in the period.
Assets-to-capital multiple
Total assets plus specified off-balance sheet items, as defined by the OSFI, divided by total regulatory capital.
Assets under administration (AUA)
Assets administered by us which are beneficially owned by clients. Services provided in respect of assets under administration are of an administrative nature, including safekeeping, collecting investment income, settling purchase and sale transactions, and record keeping.
Assets under management (AUM)
Assets managed by us which are beneficially owned by clients. Services provided in respect of assets under management include the selection of investments and the provision of investment advice. We have assets under management that are also administered by us and included in assets under administration.
Average balances
Average balances are calculated using methods intended to approximate the average of the daily balances of the period.
Average earning assets
The average carrying value of assets that give rise to our reported net interest income including deposits with banks, securities, assets purchased under reverse repurchase agreements and securities borrowed, and loans based on daily balances for the period ending October 31 in each financial year.
Basis point (bp)
One one-hundredth of a percentage point (.01%).
Canadian GAAP
Canadian generally accepted accounting principles.
Capital adequacy
The level of capital that is sufficient to underpin risk and accommodate potential unexpected increases in risk within specified regulatory targets while maintaining our business plans. This includes risks for which minimum regulatory capital requirements may not be specified.
Capital position
Quantifies the extent to which illiquid assets are funded by non-core liabilities and represents a formula-based measure of both comparative and directional structural liquidity risk.
Cash capital position
Quantifies the extent to which illiquid assets are funded by non-core liabilities and represents a formula-based measure of both comparative and directional structural liquidity risk.
Collateral
Assets pledged as security for a loan or other obligation. Collateral can take many forms, such as cash, highly rated securities, property, inventory and equipment and receivables.
Collateralized debt obligation (CDO)
An investment grade security that is backed by a pool of bonds, loans and/or any other type of debt instrument.
Covered bonds
Full recourse on-balance sheet obligations issued by banks and credit institutions that are also fully collateralized by assets over which investors enjoy a priority claim in the event of an issuer’s insolvency.
Commitments to extend credit
Unutilized amount of credit facilities available to clients either in the form of loans, bankers’ acceptances and other on-balance sheet financing, or through off-balance sheet products such as guarantees and letters of credit.
Derivative
A contract between two parties which requires little or no initial investment and where payments between the parties are dependent upon the movements in price of an underlying instrument, index or financial rate. Examples of derivatives include swaps, options, forward rate agreements and futures. The notional amount of the derivative is the contract amount used as a reference point to calculate the payments to be exchanged between the two parties, and the notional amount itself is generally not exchanged by the parties.
Dividend payout ratio
Common dividends as a percentage of net income after preferred share dividends.
Dividend yield
Dividends per common share divided by the average of the high and low share prices in the relevant period.
Documentary and commercial letters of credit
Written undertakings by a bank on behalf of its client (typically an importer), authorizing a third party (typically an exporter) to draw drafts on the bank up to a stipulated amount under specific terms and conditions. Such undertakings are established for the purpose of facilitating international trade.
Earnings per share (EPS), basic
Calculated as net income less preferred share dividends divided by the average number of shares outstanding.
Earnings per share (EPS), diluted
Calculated as net income less preferred share dividends divided by the average number of shares outstanding adjusted for the dilutive effects of stock options and other convertible securities.
Economic Capital (EC)
An estimate of the amount of equity capital required to underpin risks. It is calculated by estimating the level of capital that is necessary to support our various businesses, given their risks, consistent with our desired solvency standard and credit ratings.
Fair value
The amount of consideration that would be agreed upon in an arm’s-length transaction between knowledgeable, willing parties who are under no compulsion to act.
Guarantees and standby letters of credit
Primarily represent irrevocable assurances that a bank will make payments in the event that its client cannot meet its financial obligations to third parties. Certain other guarantees, such as bid and performance bonds, represent non-financial undertakings.
Hedge
A risk management technique used to insulate financial results from market, interest rate or foreign currency exchange risk (exposure) arising from normal banking operations. The elimination or reduction of such exposure is accomplished by establishing offsetting positions. For example, assets denominated in foreign currencies can be offset with liabilities in the same currencies or through the use of foreign exchange hedging instruments such as futures, options or foreign exchange contracts.
Hedge funds
A type of fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive strategies that are unavailable to mutual funds, including selling short, leverage, program trading, swaps, arbitrage and derivatives.
Impaired loans
Loans are classified as impaired when there has been a deterioration of credit quality to the extent that management no longer has reasonable assurance of timely collection of the full amount of principal and interest in accordance with the contractual terms of the loan agreement. Credit card balances are not classified as impaired as they are directly written off after payments are 180 days past due.
Innovative capital instruments
Capital instruments issued by special purpose entities (SPEs), whose primary purpose is to raise capital. We issue innovative capital instruments, RBC Trust Capital Securities (TruCS) and RBC Trust Subordinated Notes (TSNs), through three SPEs: RBC Capital Trust, RBC Capital Trust II and RBC Subordinated Notes Trust. As per the OSFI guidelines, innovative capital can comprise up to 15% of net Tier 1 capital with an additional 5% eligible for Tier 2 capital.
Managed basis
We report our segments on a managed basis, which is intended to measure the performance of each business segment as if it were a stand-alone business and reflect the way each segment is managed.
Royal Bank of Canada: Annual Report 2007
Glossary  181

 

 

Mark-to-market
Valuation of financial instruments using prevailing market prices or fair value as of the balance sheet date.
Master netting agreement
An agreement between us and a counterparty designed to reduce the credit risk of multiple derivative transactions through the creation of a legal right of offset of exposure in the event of a default.
Net interest income
The difference between what is earned on assets such as loans and securities and what is paid on liabilities such as deposits and subordinated debentures.
Net interest margin (average assets)
Net interest income as a percentage of total average assets.
Net interest margin (average earning assets)
Net interest income as a percentage of total average earning assets.
Non-bank sponsored asset-backed commercial paper
A short-term promissory note issued primarily by corporations, which is securitized with loans or other receivables.
Normal course issuer bid (NCIB)
A program for the repurchase of our own common shares, for cancellation through a stock exchange, that is subject to the various rules of the relevant stock exchange and securities commission.
Notional amount
The contract amount used as a reference point to calculate payments for derivatives.
Off-balance sheet financial instruments
A variety of credit-related arrangements offered to clients, which generally provides liquidity protection.
Office of the Superintendent of Financial Institutions Canada (OSFI)
The primary regulator of federally chartered financial institutions and federally administered pension plans in Canada. The OSFI’s mission is to safeguard policyholders, depositors and pension plan members from undue loss.
Options
A contract or a provision of a contract that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to specified terms.
Prepaid pension benefit cost
The cumulative excess of amounts contributed to a pension fund over the amounts recorded as pension expense.
Provision for credit losses
The amount charged to income necessary to bring the allowance for credit losses to a level determined appropriate by management. This includes both specific and general provisions.
Repurchase agreements
Involve the sale of securities for cash at a near value date and the simultaneous repurchase of the securities for value at a later date.
Residential mortgage-backed securities
Securities created through the securitization of residential mortgage loans.
Return on common equity (ROE)
Net income, less preferred share dividends, expressed as a percentage of average common equity.
Reverse repurchase agreements
Involve the purchase of securities for cash at a near value date and the simultaneous sale of the securities for value at a later date.
Risk
Financial institutions face a number of different risks that expose them to possible losses. These risks include credit risk, market risk, operational risk, liquidity and funding risk, reputation risk, regulatory and legal risk, environmental risk, insurance risk, strategic risk, competitive risk and systemic risk.
Risk-adjusted assets
As prescribed by the OSFI guidelines and used in the calculation of risk-based capital ratios. The face value of on-balance sheet assets is discounted using specified risk-weighting factors that reflect the relative risk of the asset. The risk inherent in off-balance sheet instruments is also recognized, first by determining a credit equivalent amount, and then by applying appropriate risk-weighting factors.
Securities lending
Transactions in which the owner of a security agrees to lend it under the terms of a prearranged contract to a borrower for a fee. The borrower must collateralize the security loan at all times. An intermediary such as a bank often acts as agent for the owner of the security. There are two types of securities lending arrangements: lending with and without credit or market risk indemnification. In securities lending without indemnification, the bank bears no risk of loss. For transactions in which the bank provides an indemnification, it bears risk of loss if the borrower defaults and the value of the collateral declines concurrently.
Securities sold short
A transaction in which the seller sells securities and then borrows the securities in order to deliver them to the purchaser upon settlement. At a later date, the seller buys identical securities in the market to replace the borrowed securities.
Securitization
The process by which high-quality financial assets are packaged into newly issued securities backed by these assets.
Special purpose entities (SPEs)
Entities that are typically organized for a single discrete purpose, have a limited life and serve to legally isolate the financial assets held by the SPE from the selling organization. SPEs are principally used to securitize financial and other assets in order to obtain access to funding, to mitigate credit risk and to manage capital.
Structured investment vehicle
Managed investment vehicle that holds mainly highly rated asset-backed securities and funds itself using the short-term commercial paper market as well as the medium-term note (MTN) market.
Subprime loans
Subprime lending is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. Subprime lending carries more risk for both lenders and borrowers due to the combination of higher interest rates, poorer credit histories, and adverse financial situations usually associated with subprime applicants.
Survival horizon
Measures the length of time over which we would have sufficient funds to repay our maturing liabilities and finance off-balance sheet commitments if access to wholesale unsecured funding became suddenly unavailable and liquid assets, but no portion of mortgages and loans, were monetized.
Synthetic securitization
The transfer of risks relating to selected elements of our financial assets to unaffiliated third parties through the use of certain financial instruments such as credit default swaps and guarantees.
Taxable equivalent basis (teb)
Income from certain specified tax-advantaged sources is increased to a level that would make it comparable to income from taxable sources. There is an offsetting adjustment in the tax provision, thereby generating the same after-tax net income.
Tier 1 capital and Tier 1 capital ratio
Tier 1 capital is considered to be the most permanent in nature without creating a fixed charge against income. As defined by the OSFI, it includes common equity, retained earnings, non-cumulative preferred shares, and innovative capital instruments. The Tier 1 capital ratio is calculated by dividing Tier 1 capital by risk-adjusted assets.
Total capital ratio
The percentage of risk-adjusted assets supported by capital using the guidelines of the OSFI based on standards issued by the Bank for International Settlements and Canadian GAAP financial information.
Trust Capital Securities (TruCS)
Transferable trust units issued by special purpose entities, RBC Capital Trust or RBC Capital Trust II, for the purpose of raising innovative Tier 1 capital.
Trust Subordinated Notes (TSNs)
Transferable trust units issued by RBC Subordinated Notes Trust for the purpose of raising innovative Tier 2 capital.
U.S. GAAP
U.S. generally accepted accounting principles.
Value-at-Risk (VaR)
A generally accepted risk-measurement concept that uses statistical models based on historical information to estimate within a given level of confidence the maximum loss in market value we would experience in our trading portfolio from an adverse one-day movement in market rates and prices.
Variable interest entity (VIE)
An entity which either does not have sufficient equity at risk to finance its activities without additional subordinated financial support, or where the holders of the equity at risk lack the characteristics of a controlling financial interest.
Royal Bank of Canada: Annual Report 2007
182  Glossary

 

 

Consolidated Financial Statements

111 Management’s responsibility for financial reporting
111 Report of Independent Registered Chartered Accountants
112 Management’s report on internal control over financial reporting
112 Report of Independent Registered Chartered Accountants
Consolidated Financial Statements
113 Consolidated Balance Sheets
114 Consolidated Statements of Income
115 Consolidated Statements of Comprehensive Income and Changes in Shareholders’ Equity
116 Consolidated Statements of Cash Flows
Notes to the Consolidated Financial Statements
117 Note 1 Significant accounting policies and estimates
124 Note 2 Fair value of financial instruments
127 Note 3 Securities
129 Note 4 Loans
130 Note 5 Securitizations
132 Note 6 Variable interest entities (VIEs)
133 Note 7 Derivative financial instruments and hedging activities
137 Note 8 Premises and equipment
137 Note 9 Joint venture
138 Note 10 Goodwill and other intangibles
139 Note 11 Significant acquisitions and dispositions
140 Note 12 Other assets
141 Note 13 Deposits
142 Note 14 Insurance
142 Note 15 Other liabilities
143 Note 16 Subordinated debentures
144 Note 17 Trust capital securities
145 Note 18 Preferred share liabilities and share capital
147 Note 19 Non-controlling interest in subsidiaries
148 Note 20 Pensions and other post-employment benefits
150 Note 21 Stock-based compensation
153 Note 22 Trading revenue
153 Note 23 Business realignment charges
154 Note 24 Income taxes
155 Note 25 Earnings per share
156 Note 26 Concentrations of credit risk
156 Note 27 Guarantees, commitments and contingencies
159 Note 28 Contractual repricing and maturity schedule
160 Note 29 Related party transactions
161 Note 30 Results by business and geographic segment
163 Note 31 Reconciliation of the application of Canadian and United States generally accepted accounting principles
175 Note 32 Parent company information
Royal Bank of Canada: Annual Report 2007
110    Consolidated Financial Statements

 

 

MANAGEMENT’s RESPONSIBILITY FOR FINANCIAL REPORTING
The accompanying consolidated financial statements of Royal Bank of Canada (RBC) were prepared by management, which is responsible for the integrity and fairness of the information presented, including the many amounts that must of necessity be based on estimates and judgments. These consolidated financial statements were prepared in accordance with Canadian generally accepted accounting principles (GAAP) pursuant to Subsection 308 of the Bank Act (Canada), which states that, except as otherwise specified by the Superintendent of Financial Institutions Canada, the financial statements are to be prepared in accordance with Canadian GAAP. Financial information appearing throughout our management’s discussion and analysis is consistent with these consolidated financial statements.
     In discharging our responsibility for the integrity and fairness of the consolidated financial statements and for the accounting systems from which they are derived, we maintain the necessary system of internal controls designed to ensure that transactions are authorized, assets are safeguarded and proper records are maintained. These controls include quality standards in hiring and training of employees, policies and procedures manuals, a corporate code of conduct and accountability for performance within appropriate and well-defined areas of responsibility.
     The system of internal controls is further supported by a compliance function, which is designed to ensure that we and our employees comply with securities legislation and conflict of interest rules, and by an internal audit staff, which conducts periodic audits of all aspects of our operations.
     The Board of Directors oversees management’s responsibilities for financial reporting through an Audit Committee, which is composed entirely of directors who are neither officers nor employees of RBC.
This Committee reviews our consolidated financial statements and recommends them to the Board for approval. Other key responsibilities of the Audit Committee include reviewing our existing internal control procedures and planned revisions to those procedures, and advising the directors on auditing matters and financial reporting issues. Our Compliance Officer and Chief Internal Auditor have full and unrestricted access to the Audit Committee.
     The Office of the Superintendent of Financial Institutions, Canada (OSFI) examines and inquires into the business and affairs of RBC as deemed necessary to determine whether the provisions of the Bank Act are being complied with, and that RBC is in sound financial condition. In carrying out its mandate, OSFI strives to protect the rights and interests of depositors and creditors of RBC.
     Deloitte & Touche LLP, Independent Registered Chartered Accountants appointed by the shareholders of RBC upon the recommendation of the Audit Committee and Board, have performed an independent audit of the consolidated financial statements and their report follows. The auditors have full and unrestricted access to the Audit Committee to discuss their audit and related findings.
Gordon M. Nixon
President and Chief Executive Officer
Janice R. Fukakusa
Chief Financial Officer
Toronto, November 29, 2007
REPORT OF INDEPENDENT REGISTERED CHARTERED ACCOUNTANTS
To the Shareholders of Royal Bank of Canada
We have audited the consolidated balance sheets of Royal Bank of Canada (the “Bank”) as at October 31, 2007 and 2006 and the consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for each of the three years in the period ended October 31, 2007. These financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
     With respect to the consolidated financial statements as at and for the years ended October 31, 2007 and 2006, we conducted our audits in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States). With respect to the consolidated financial statements as at and for the year ended October 31, 2005, we conducted our audit in accordance with Canadian generally accepted auditing standards. These standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
     In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Bank as at October 31, 2007 and 2006 and the results of its operations and its cash flows for each of the three years in the period ended October 31, 2007 in accordance with Canadian generally accepted accounting principles.
     We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Bank’s internal control over financial reporting as of October 31, 2007 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 29, 2007 expressed an unqualified opinion on the Bank’s internal control over financial reporting.
Deloitte & Touche LLP
Independent Registered Chartered Accountants
Licensed Public Accountants
Toronto, Canada
November 29, 2007
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements    111

 

 

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Royal Bank of Canada (RBC) is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of, the President and Chief Executive Officer and the Chief Financial Officer and effected by the Board of Directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. It includes those policies and procedures that:
•   pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, the transactions related to and dispositions of RBC’s assets
 
•   provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and RBC receipts and expenditures are made only in accordance with authorizations of management and RBC’s directors
 
•   provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of RBC assets that could have a material effect on RBC’s financial statements.
Due to its inherent limitations, internal control over financial reporting may not prevent or detect misstatements on a timely basis. Also, projections of any evaluation of the effectiveness of internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
     Management assessed the effectiveness of RBC’s internal control over financial reporting as of October 31, 2007, based on the criteria set forth in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management concluded that, as of October 31, 2007, RBC’s internal control over financial reporting is effective. Also, management determined that there were no material weaknesses in RBC’s internal control over financial reporting as of October 31, 2007.
     RBC’s internal control over financial reporting as of October 31, 2007 has been audited by Deloitte & Touche LLP, Independent Registered Chartered Accountants, who also audited RBC’s Consolidated Financial Statements for the year ended October 31, 2007, as stated in the Report of Independent Registered Chartered Accountants, which report expressed an unqualified opinion on the effectiveness of RBC’s internal control over financial reporting.
Gordon M. Nixon
President and Chief Executive Officer
Janice R. Fukakusa
Chief Financial Officer
Toronto, November 29, 2007
Report of Independent Registered Chartered Accountants
To the Shareholders of Royal Bank of Canada
We have audited the internal control over financial reporting of Royal Bank of Canada (the “Bank”) as of October 31, 2007 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Bank’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Bank’s internal control over financial reporting based on our audit.
     We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
     A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
     Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
     In our opinion, the Bank maintained, in all material respects, effective internal control over financial reporting as of October 31, 2007 based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
     We have also audited, in accordance with Canadian generally accepted auditing standards and the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as at and for the year ended October 31, 2007 of the Bank and our report dated November 29, 2007 expressed an unqualified opinion on those consolidated financial statements.
Deloitte & Touche LLP
Independent Registered Chartered Accountants
Licensed Public Accountants
Toronto, Canada
November 29, 2007
Royal Bank of Canada: Annual Report 2007
112  Consolidated Financial Statements

 

 

CONSOLIDATED BALANCE SHEETS
                 
As at October 31 (C$ millions)   2007     2006  
 
Assets
                
 
                
Cash and due from banks
   $ 4,226     $ 4,401  
 
Interest-bearing deposits with banks
     11,881       10,502  
 
Securities (Note 3)
                
Trading
     148,246       147,237  
Available-for-sale
     30,009       —  
Investments
     —       37,632  
 
 
     178,255       184,869  
 
Assets purchased under reverse repurchase agreements and securities borrowed
     64,313       59,378  
 
Loans (Notes 4 and 5)
                
Retail
     169,462       151,050  
Wholesale
     69,967       58,889  
 
 
     239,429       209,939  
Allowance for loan losses
     (1,493 )     (1,409 )
 
 
     237,936       208,530  
 
Other
                
Customers’ liability under acceptances
     11,786       9,108  
Derivatives (Note 7)
     66,585       37,729  
Premises and equipment, net (Note 8)
     2,131       1,818  
Goodwill (Note 10)
     4,752       4,304  
Other intangibles (Note 10)
     628       642  
Assets of operations held for sale
     —       82  
Other assets (Note 12)
     17,853       15,417  
 
 
     103,735       69,100  
 
 
   $ 600,346     $ 536,780  
 
Liabilities and shareholders’ equity
                
 
                
Deposits (Note 13)
                
Personal
   $ 116,557     $ 114,040  
Business and government
     219,886       189,140  
Bank
     28,762       40,343  
 
 
     365,205       343,523  
 
Other
                
Acceptances
     11,786       9,108  
Obligations related to securities sold short
     44,689       38,252  
Obligations related to assets sold under repurchase agreements and securities loaned
     37,033       41,103  
Derivatives (Note 7)
     72,010       42,094  
Insurance claims and policy benefit liabilities (Note 14)
     7,283       7,337  
Liabilities of operations held for sale
     —       32  
Other liabilities (Note 15)
     28,483       22,649  
 
 
     201,284       160,575  
 
Subordinated debentures (Note 16)
     6,235       7,103  
 
Trust capital securities (Note 17)
     1,400       1,383  
 
Preferred share liabilities (Note 18)
     300       298  
 
Non-controlling interest in subsidiaries (Note 19)
     1,483       1,775  
 
Shareholders’ equity (Note 18)
                
Preferred shares
     2,050       1,050  
Common shares (shares issued — 1,276,260,033 and 1,280,889,745)
     7,300       7,196  
Contributed surplus
     235       292  
Treasury shares — preferred (shares held — 248,800 and 93,700)
     (6 )     (2 )
— common (shares held — 2,444,320 and 5,486,072)
     (101 )     (180 )
Retained earnings
     18,167       15,771  
Accumulated other comprehensive income (loss)
     (3,206 )     (2,004 )
 
 
     24,439       22,123  
 
 
   $ 600,346     $ 536,780  
 
     
Gordon M. Nixon
  Robert B. Peterson
President and Chief Executive Officer
  Director
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  113

 

 

CONSOLIDATED STATEMENTS OF INCOME
                         
For the year ended October 31 (C$ millions)   2007     2006     2005  
 
Interest income
                        
Loans
   $ 14,724     $ 12,708     $ 10,790  
Securities
     7,665       6,189       4,606  
Assets purchased under reverse repurchase agreements and securities borrowed
     3,450       2,827       1,354  
Deposits with banks
     538       480       231  
 
 
     26,377       22,204       16,981  
 
Interest expense
                        
Deposits
     13,770       10,708       6,946  
Other liabilities
     4,737       4,281       2,800  
Subordinated debentures
     338       419       442  
 
 
     18,845       15,408       10,188  
 
Net interest income
     7,532       6,796       6,793  
 
Non-interest income
                        
Insurance premiums, investment and fee income
     3,152       3,348       3,270  
Trading revenue
     2,261       2,574       1,594  
Investment management and custodial fees
     1,579       1,301       1,232  
Mutual fund revenue
     1,473       1,242       962  
Securities brokerage commissions
     1,353       1,243       1,163  
Service charges
     1,303       1,216       1,153  
Underwriting and other advisory fees
     1,217       1,024       1,026  
Foreign exchange revenue, other than trading
     533       438       407  
Card service revenue
     491       496       579  
Credit fees
     293       241       187  
Securitization revenue (Note 5)
     261       257       285  
Net gain on sale of available-for-sale securities (Note 3)
     63       —       —  
Net gain on sale of investment securities
     —       88       85  
Other
     951       373       448  
 
Non-interest income
     14,930       13,841       12,391  
 
Total revenue
     22,462       20,637       19,184  
 
Provision for credit losses (Note 4)
     791       429       455  
 
Insurance policyholder benefits, claims and acquisition expense
     2,173       2,509       2,625  
 
Non-interest expense
                        
Human resources (Notes 20 and 21)
     7,860       7,268       6,682  
Equipment
     1,009       957       960  
Occupancy
     839       792       749  
Communications
     723       687       632  
Professional fees
     530       546       500  
Outsourced item processing
     308       298       296  
Amortization of other intangibles (Note 10)
     96       76       50  
Other
     1,108       871       1,488  
 
 
     12,473       11,495       11,357  
 
Business realignment charges (Note 23)
     —       —       45  
 
Income from continuing operations before income taxes
     7,025       6,204       4,702  
Income taxes (Note 24)
     1,392       1,403       1,278  
 
Net income before non-controlling interest
     5,633       4,801       3,424  
Non-controlling interest in net income of subsidiaries
     141       44       (13 )
 
Net income from continuing operations
     5,492       4,757       3,437  
Net loss from discontinued operations
     —       (29 )     (50 )
 
Net income
   $ 5,492     $ 4,728     $ 3,387  
 
Preferred dividends (Note 18)
     (88 )     (60 )     (42 )
Net gain on redemption of preferred shares
     —       —       4  
 
Net income available to common shareholders
   $ 5,404     $ 4,668     $ 3,349  
 
Average number of common shares (in thousands) (Note 25)
     1,273,185       1,279,956       1,283,433  
Basic earnings per share (in dollars)
   $ 4.24     $ 3.65     $ 2.61  
Basic earnings per share from continuing operations (in dollars)
   $ 4.24     $ 3.67     $ 2.65  
Basic earnings (loss) per share from discontinued operations (in dollars)
   $ —     $ (.02 )   $ (.04 )
 
                        
Average number of diluted common shares (in thousands) (Note 25)
     1,289,314       1,299,785       1,304,680  
Diluted earnings per share (in dollars)
   $ 4.19     $ 3.59     $ 2.57  
Diluted earnings per share from continuing operations (in dollars)
   $ 4.19     $ 3.61     $ 2.61  
Diluted earnings (loss) per share from discontinued operations (in dollars)
   $ —     $ (.02 )   $ (.04 )
 
Dividends per share (in dollars)
   $ 1.82     $ 1.44     $ 1.18  
 
Royal Bank of Canada: Annual Report 2007
114  Consolidated Financial Statements

 

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
                         
For the year ended October 31 (C$ millions)   2007     2006     2005  
 
Net income
   $ 5,492     $ 4,728     $ 3,387  
Other comprehensive income, net of taxes
                        
Net unrealized gains (losses) on available-for-sale securities
     (93 )     —       —  
Reclassification of (gains) losses on available-for-sale securities to income
     28       —       —  
 
 
     (65 )     —       —  
 
Unrealized foreign currency translation gains (losses)
     (2,965 )     (501 )     (624 )
Reclassification of (gains) losses on foreign currency translation to income
     (42 )     2       5  
Net foreign currency translation gains (losses) from hedging activities
     1,804       269       401  
 
 
     (1,203 )     (230 )     (218 )
 
Net gains (losses) on derivatives designated as cash flow hedges
     80       —       —  
Reclassification to income of (gains) losses on derivatives designated as cash flow hedges
     31       —       —  
 
 
     111       —       —  
 
Other comprehensive income (loss)
     (1,157 )     (230 )     (218 )
 
Total comprehensive income
   $ 4,335     $ 4,498     $ 3,169  
 
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
                         
For the year ended October 31 (C$ millions)   2007     2006     2005  
 
Preferred shares (Note 18)
                        
Balance at beginning of year
   $ 1,050     $ 700     $ 532  
Issued
     1,150       600       300  
Redeemed for cancellation
     (150 )     (250 )     (132 )
 
Balance at end of year
     2,050       1,050       700  
 
Common shares (Note 18)
                        
Balance at beginning of year
     7,196       7,170       6,988  
Issued
     170       127       214  
Purchased for cancellation
     (66 )     (101 )     (32 )
 
Balance at end of year
     7,300       7,196       7,170  
 
Contributed surplus
                        
Balance at beginning of year
     292       265       169  
Renounced stock appreciation rights
     (6 )     (2 )     (6 )
Stock-based compensation awards
     (46 )     (18 )     26  
Gain on redemption of preferred shares
     —       —       7  
Initial adoption of AcG-15, Consolidation of Variable Interest Entities
     —       —       54  
Other
     (5 )     47       15  
 
Balance at end of year
     235       292       265  
 
Treasury shares — preferred (Note 18)
                        
Balance at beginning of year
     (2 )     (2 )     —  
Sales
     33       51       —  
Purchases
     (37 )     (51 )     (2 )
 
Balance at end of year
     (6 )     (2 )     (2 )
 
Treasury shares — common (Note 18)
                        
Balance at beginning of year
     (180 )     (216 )     (294 )
Sales
     175       193       179  
Purchases
     (96 )     (157 )     (47 )
Initial adoption of AcG-15, Consolidation of Variable Interest Entities
     —       —       (54 )
 
Balance at end of year
     (101 )     (180 )     (216 )
 
Retained earnings
                        
Balance at beginning of year
     15,771       13,704       12,065  
Transition adjustment — Financial instruments (1)
     (86 )     —       —  
Net income
     5,492       4,728       3,387  
Preferred share dividends (Note 18)
     (88 )     (60 )     (42 )
Common share dividends (Note 18)
     (2,321 )     (1,847 )     (1,512 )
Premium paid on common shares purchased for cancellation
     (580 )     (743 )     (194 )
Issuance costs and other
     (21 )     (11 )     —  
 
Balance at end of year
     18,167       15,771       13,704  
 
Accumulated other comprehensive income (loss)
                        
Transition adjustment — Financial instruments (1)
     (45 )     —       —  
Unrealized gains and losses on available-for-sale securities
     (65 )     —       —  
Unrealized foreign currency translation gains and losses, net of hedging activities
     (3,207 )     (2004 )     (1,774 )
Gains and losses on derivatives designated as cash flow hedges
     111       —       —  
 
Balance at end of year
     (3,206 )     (2,004 )     (1,774 )
 
Retained earnings and Accumulated other comprehensive income
     14,961       13,767       11,930  
 
Shareholders’ equity at end of year
   $ 24,439     $ 22,123     $ 19,847  
 
(1)   The transition adjustment relates to the implementation of the new financial instruments accounting standards. Refer to Note 1.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  115

 

 

 
CONSOLIDATED STATEMENTS OF CASH FLOWS
                         
For the year ended October 31 (C$ millions)   2007     2006     2005  
 
Cash flows from operating activities
                        
Net income from continuing operations
   $ 5,492     $ 4,757     $ 3,437  
Adjustments to determine net cash from (used in) operating activities
                        
Provision for credit losses
     791       429       455  
Depreciation
     434       405       414  
Business realignment payments
     (38 )     (74 )     (94 )
Future income taxes
     (147 )     144       (482 )
Amortization of other intangibles
     96       76       50  
(Gain) loss on sale of premises and equipment
     (16 )     (16 )     (21 )
(Gain) loss on loan securitizations
     (41 )     (16 )     (101 )
(Gain) loss on sale of available-for-sale securities
     (63 )     —       —  
(Gain) loss on sale of investment securities
     —       (88 )     (85 )
Changes in operating assets and liabilities
                        
Insurance claims and policy benefit liabilities
     (54 )     220       629  
Net change in accrued interest receivable and payable
     (28 )     217       (5 )
Current income taxes
     1,034       (203 )     (9 )
Derivative assets
     (28,856 )     1,105       63  
Derivative liabilities
     29,916       (498 )     391  
Trading securities
     9,623       (21,477 )     (36,438 )
Net change in brokers and dealers receivable and payable
     (317 )     (1,017 )     1,334  
Other
     1,647       1,036       840  
 
Net cash from (used in) operating activities from continuing operations
     19,473       (15,000 )     (29,622 )
Net cash from (used in) operating activities from discontinued operations
     —       4       95  
 
Net cash from (used in) operating activities
     19,473       (14,996 )     (29,527 )
 
Cash flows from investing activities
                        
Change in interest-bearing deposits with banks
     (1,379 )     (5,265 )     1,030  
Change in loans, net of loan securitizations
     (39,569 )     (33,534 )     (27,670 )
Proceeds from loan securitizations
     8,020       8,139       5,607  
Proceeds from sale of available-for-sale securities
     7,565       —       —  
Proceeds from sale of investment securities
     —       14,709       25,628  
Proceeds from maturity of available-for-sale securities
     18,784       —       —  
Proceeds from maturity of investment securities
     —       28,222       18,431  
Purchases of available-for-sale securities
     (24,097 )     —       —  
Purchases of investment securities
     —       (38,474 )     (36,373 )
Net acquisitions of premises and equipment
     (706 )     (511 )     (383 )
Change in assets purchased under reverse repurchase agreements and securities borrowed
     (4,935 )     (16,405 )     3,976  
Net cash from (used in) acquisitions
     (373 )     (256 )     —  
 
Net cash from (used in) investing activities from continuing operations
     (36,690 )     (43,375 )     (9,754 )
Net cash from (used in) investing activities from discontinued operations
     —       140       2,027  
 
Net cash from (used in) investing activities
     (36,690 )     (43,235 )     (7,727 )
 
Cash flows from financing activities
                        
Change in deposits
     17,831       36,663       35,001  
Issue of RBC Trust Capital Securities
     —       —       1,200  
Issue of subordinated debentures
     87       —       800  
Repayment of subordinated debentures
     (989 )     (953 )     (786 )
Issue of preferred shares
     1,150       600       300  
Redemption of preferred shares for cancellation
     (150 )     (250 )     (132 )
Issuance costs
     (23 )     (6 )     (3 )
Issue of common shares
     155       116       198  
Purchase of common shares for cancellation
     (646 )     (844 )     (226 )
Sales of treasury shares
     208       244       179  
Purchase of treasury shares
     (133 )     (208 )     (49 )
Dividends paid
     (2,278 )     (1,807 )     (1,469 )
Dividends/distributions paid by subsidiaries to non-controlling interests
     (59 )     (47 )     (13 )
Change in obligations related to assets sold under repurchase agreements and securities loaned
     (4,070 )     17,722       (3,092 )
Change in obligations related to securities sold short
     6,436       5,861       7,386  
Change in short-term borrowings of subsidiaries
     (145 )     620       (628 )
 
Net cash from (used in) financing activities from continuing operations
     17,374       57,711       38,666  
 
Net cash from (used in) financing activities
     17,374       57,711       38,666  
 
Effect of exchange rate changes on cash and due from banks
     (332 )     (80 )     (122 )
 
Net change in cash and due from banks
     (175 )     (600 )     1,290  
Cash and due from banks at beginning of year
     4,401       5,001       3,711  
 
Cash and due from banks at end of year
   $ 4,226     $ 4,401     $ 5,001  
 
 
Supplemental disclosure of cash flow information
                        
Amount of interest paid in year
   $ 18,494     $ 14,678     $ 10,109  
Amount of income taxes paid in year
   $ 1,352     $ 1,682     $ 1,987  
 
Royal Bank of Canada: Annual Report 2007
116  Consolidated Financial Statements

 

 

Consolidated Financial Statements (all tabular amounts are in millions of Canadian dollars, except per share amounts)
 
NOTE 1 SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES
The accompanying Consolidated Financial Statements have been prepared in accordance with Subsection 308 of the Bank Act (Canada) (the Act), which states that, except as otherwise specified by the Office of the Superintendent of Financial Institutions Canada (OSFI), our Consolidated Financial Statements are to be prepared in accordance with Canadian generally accepted accounting principles (GAAP). The significant accounting policies used in the preparation of these financial statements, including the accounting requirements of the OSFI, are summarized below. These accounting policies conform, in all material respects, to Canadian GAAP.
Basis of consolidation
Our Consolidated Financial Statements include the assets and liabilities and results of operations of all subsidiaries and variable interest entities (VIEs) where we are the Primary Beneficiary after elimination of intercompany transactions and balances. The equity method is used to account for investments in associated corporations and limited partnerships in which we have significant influence. These investments are reported in Other assets. Our share of earnings, gains and losses realized on dispositions and writedowns to reflect other-than-temporary impairment in the value of these investments are included in Non-interest income. The proportionate consolidation method is used to account for investments in joint ventures in which we exercise joint control, whereby our pro rata share of assets, liabilities, income and expenses is consolidated.
Significant accounting changes
Financial Instruments
On November 1, 2006, we adopted three new financial instruments accounting standards that were issued by the Canadian Institute of Chartered Accountants (CICA): Handbook Section 1530, Comprehensive Income (Section 1530), Handbook Section 3855, Financial Instruments — Recognition and Measurement (Section 3855), and Handbook Section 3865, Hedges (Section 3865). Comparative amounts for prior periods have not been restated.
Comprehensive Income
Section 1530 introduces Comprehensive Income, which consists of Net income and Other comprehensive income (OCI). OCI represents changes in Shareholders’ equity during a period arising from transactions and other events with non-owner sources and includes unrealized gains and losses on financial assets classified as available-for-sale, unrealized foreign currency translation gains or losses arising from self-sustaining foreign operations, net of hedging activities, and changes in the fair value of the effective portion of cash flow hedging instruments. We have included in our Consolidated Financial Statements a Consolidated Statement of Comprehensive Income for the changes in these items, net of taxes, since November 1, 2006, while the cumulative changes in OCI are included in Accumulated other comprehensive income (loss) (AOCI), which is presented as a new category of Shareholders’ equity on our Consolidated Balance Sheets.
Financial Instruments — Recognition and Measurement
Section 3855 establishes standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. It requires that financial assets and financial liabilities, including derivatives, be recognized on our Consolidated Balance Sheets when we become a party to the contractual provisions of a financial instrument or non-financial derivative contract. Under this standard, all financial instruments are required to be measured at fair value on initial recognition except for certain related party transactions. Measurement in subsequent periods depends on whether the financial instrument has been classified as held-for-trading, available-for-sale, held-to-maturity, loans and receivables, or other financial liabilities. Transaction costs are expensed as incurred for financial instruments classified or designated as held-for-trading. For other financial instruments, transaction costs are capitalized on initial recognition.
     Financial assets and financial liabilities held-for-trading are measured at fair value with changes in those fair values recognized in Non-interest income. Financial assets held-to-maturity, loans and receivables, and other financial liabilities are measured at amortized cost using the effective interest method. Available-for-sale financial assets, which include loan substitute securities, are measured at fair value with unrealized gains and losses, including changes in foreign exchange rates, being recognized in OCI. Investments in equity instruments classified as available-for-sale that do not have a quoted market price in an active market are measured at cost.
     Derivative instruments are recorded on our Consolidated Balance Sheets at fair value, including those derivatives that are embedded in financial or non-financial contracts that are not closely related to the host contracts. Changes in the fair values of derivative instruments are recognized in Net income except for derivatives designated as effective cash flow hedges or hedges of foreign currency exposure of a net investment in a self-sustaining foreign operation, the changes in fair value of which are recognized in OCI.
     Section 3855 also provides an entity the option to designate a financial instrument as held-for-trading (the fair value option) on its initial recognition or upon adoption of the standard, even if the financial instrument was not acquired or incurred principally for the purpose of selling or repurchasing it in the near term. An instrument that is classified as held-for-trading by way of this fair value option must have a reliable fair value and satisfy one of the following criteria established by the OSFI: (i) when doing so eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from measuring assets or liabilities, or recognizing gains and losses on them on a different basis; (ii) it belongs to a group of financial assets or financial liabilities or both that are managed and evaluated on a fair value basis in accordance with our risk management or investment strategy, and are reported to senior management, on that basis; or (iii) it is an embedded derivative in a financial or non-financial host contract and the derivative is not closely related to the host contract.
     The principal categories of our financial assets that we designated as held-for-trading using the fair value option include (i) investments supporting the policy benefit liabilities on life and health insurance contracts issued by our insurance operations; (ii) investments used to offset exposures under derivative contracts in relation to our sales and trading activities; (iii) certain loans to customers whose related hedging derivatives are measured at fair value; and (iv) assets purchased under reverse repurchase agreements that form part of our trading portfolio which is managed and evaluated on a fair value basis. Financial liabilities designated as held-for-trading include (i) deposits and structured notes with embedded derivatives that are not closely related to the host contracts; (ii) assets sold under repurchase agreements that form part of our trading portfolio which is managed and evaluated on a fair value basis; and (iii) certain deposits to offset the impact of related hedging derivatives measured at fair value. Fair value designation for these financial assets and financial liabilities significantly reduces the measurement inconsistencies.
     Other significant accounting implications arising upon the adoption of Section 3855 include the use of the effective interest method for any transaction costs or fees, premiums or discounts earned on financial instruments measured at amortized cost, and the recognition of the inception fair value of the obligation undertaken in issuing a guarantee that meets the definition of a guarantee pursuant to CICA Accounting Guideline 14, Disclosure of Guarantees (AcG-14).
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  117

 

 

 
NOTE 1 SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES (continued)
Subsequent remeasurement at fair value is not required unless the financial guarantee also meets the definition of a derivative. These guarantees are remeasured at fair value at each balance sheet date and reported as a derivative in Other assets or Other liabilities, as appropriate.
Hedges
Section 3865 specifies the criteria that must be satisfied in order for hedge accounting to be applied and the accounting for each of the permitted hedging strategies. We use derivatives and non-derivative financial instruments in our hedging strategies to manage our exposures to interest, currency, credit and other market risks. When derivatives are used to manage our own exposures, we determine for each derivative whether hedge accounting can be applied. Where hedge accounting can be applied, a hedging relationship is designated as a fair value hedge, a cash flow hedge or a hedge of foreign currency exposure of a net investment in a self-sustaining foreign operation. For our detailed accounting policy on hedge accounting refer to the Derivatives section below in Note 1.
Impact upon adoption of Sections 1530, 3855 and 3865
The transition adjustments attributable to the remeasurement of financial assets and financial liabilities at fair value, other than financial assets classified as available-for-sale and hedging instruments designated as cash flow hedges or hedges of foreign currency exposure of net investment in self-sustaining foreign operations, were recognized in opening Retained earnings as at November 1, 2006. Adjustments arising from remeasuring financial assets classified as available-for-sale at fair value were recognized in opening AOCI as at that date.
     For hedging relationships existing prior to adopting Section 3865 that continue to qualify for hedge accounting under the new standard, the transition accounting is as follows: (i) Fair value hedges — any gain or loss on the hedging instrument was recognized in opening Retained earnings and the carrying amount of the hedged item was adjusted by the cumulative change in fair value attributable to the designated hedged risk and was also included in opening Retained earnings; (ii) Cash flow hedges and hedges of net investments in self-sustaining foreign operations — the effective portion of any gain or loss on the hedging instrument was recognized in AOCI and the cumulative ineffective portion was included in opening Retained earnings.
     We recorded the following transition adjustments in our Consolidated Financial Statements: (i) a reduction of $86 million, net of taxes, to our opening Retained earnings, representing changes made to the value of certain financial instruments and the ineffective portion of qualifying hedges, in compliance with the measurement basis under the new standards including those related to the use of fair value option; and (ii) recognition in AOCI of $45 million, net of taxes, related to the net losses for available-for-sale financial assets and cumulative losses on the effective portion of our cash flow hedges that are now required to be recognized under Sections 3855 and 3865. In addition, we have reclassified to AOCI $2,004 million of net unrealized foreign currency losses on net investments in self-sustaining foreign operations that were previously presented as a separate item in Shareholders’ equity.
Variable Interest Entities
On February 1, 2007, we adopted CICA Emerging Issues Committee Abstract No. 163, Determining the Variability to be Considered in Applying AcG-15 (EIC-163). EIC-163 provides additional clarification on how to analyze and consolidate VIEs. The implementation of EIC-163 resulted in the deconsolidation of certain investment funds; however, the impact was not material to our consolidated financial position or results of operations.
Convertible and Other Debt Instruments with Embedded Derivatives
On August 1, 2007, we adopted CICA Emerging Issues Committee Abstract No. 164, Convertible and Other Debt Instruments with Embedded Derivatives (EIC-164). EIC-164 provides clarification regarding the accounting treatment for certain types of convertible debt instruments, their classification as liabilities or equity, and the implications on earnings per share. It also provides guidance on whether these instruments contain any embedded derivatives that are required to be accounted for separately. The adoption of EIC-164 was not material to our consolidated financial position or results of operations.
Accounting Policy Choice for Transaction Costs
On June 1, 2007, CICA Emerging Issues Committee issued Abstract No. 166, Accounting Policy Choice for Transaction Costs (EIC-166). This EIC addresses the accounting policy choice of expensing or adding transaction costs related to the acquisition of financial assets and financial liabilities that are classified as other than held-for-trading. Specifically, it requires the same accounting policy choice be applied to all similar financial instruments classified as other than held-for-trading, but permits a different policy choice for financial instruments that are not similar. EIC-166 became effective for us on September 30, 2007 and requires retroactive application to all transaction costs accounted for in accordance with Section 3855. Our current recognition policy for transaction costs, which was adopted on November 1, 2006, is consistent with this guidance.
The accounting policies described below have been updated to reflect the requirements under the new financial instruments accounting standards, and where applicable, include a discussion on the policies used in the prior periods for comparative purposes.
Translation of foreign currencies
Monetary assets and liabilities denominated in foreign currencies are translated into Canadian dollars at rates prevailing at the balance sheet date. Non-monetary assets and liabilities are translated into Canadian dollars at historical rates. Income and expenses denominated in foreign currencies are translated at average rates of exchange for the year.
     Assets and liabilities of our self-sustaining operations with functional currencies other than the Canadian dollar are translated into Canadian dollars at rates prevailing at the balance sheet date, and income and expenses of these foreign operations are translated at average rates of exchange for the year.
     Unrealized gains or losses arising as a result of the translation of our foreign self-sustaining operations along with the effective portion of related hedges are reported as a component of OCI on an after-tax basis. Prior to November 1, 2006, these amounts were included in Shareholders’ equity. Upon disposal or dilution of our interest in such investments, an appropriate portion of the accumulated net translation gains or losses is included in Non-interest income.
     Other foreign currency translation gains and losses are included in Non-interest income.
Securities
Securities are classified, based on management’s intentions, as held-for-trading, available-for-sale or held-to-maturity.
     Held-for-trading securities include securities purchased for sale in the near term and securities designated as held-for-trading under the fair value option are reported at fair value. Obligations to deliver Trading securities sold but not yet purchased are recorded as liabilities and carried at fair value. Realized and unrealized gains and losses on these securities are recorded as Trading revenue in Non-interest income. Dividend and interest income accruing on Trading securities is recorded in Interest income. Interest and dividends accrued on interest-bearing and equity securities sold short are recorded in Interest expense.
Royal Bank of Canada: Annual Report 2007
118  Consolidated Financial Statements

 

 

     Available-for-sale securities include (i) securities which may be sold in response to or in anticipation of changes in interest rates and resulting prepayment risk, changes in foreign currency risk, changes in funding sources or terms, or to meet liquidity needs; and (ii) loan substitute securities which are client financings that have been structured as after-tax investments rather than conventional loans in order to provide the clients with a borrowing rate advantage. Available-for-sale securities are measured at fair value with unrealized gains and losses, including changes in foreign exchange rates, recognized in OCI net of tax. Purchase premiums or discounts on available-for-sale securities are amortized over the life of the security using the effective interest method and are recognized in Net interest income. Investments in equity instruments classified as Available-for-sale that do not have a quoted market price in an active market are measured at cost.
     Held-to-maturity securities are debt securities where we have the intention and ability to hold the investment until its maturity date. These securities are carried at amortized cost using the effective interest method. Dividends, interest income and amortization of premiums and discounts on debt securities are recorded in Net interest income. We hold a nominal amount of held-to-maturity securities in our normal course of business. All held-to-maturity securities have been included with Available-for-sale securities on our Consolidated Balance Sheets.
     Gains and losses realized on disposal of available-for-sale securities are included in Gain on sale of securities in Non-interest income. Both available-for-sale and held-to-maturity securities are subject to periodic impairment review.
     Prior to November 1, 2006, all investment securities, other than Trading securities, were recorded on our Consolidated Balance Sheets as Investment securities at amortized cost, and loan substitute securities were accorded the accounting treatment applicable to loans and, where required, reduced by an allowance for credit losses.
     We account for all of our securities using settlement date accounting except that changes in fair value between the trade date and settlement date are reflected in income for securities classified or designated as held-for-trading while changes in the fair value of available-for-sale securities between the trade and settlement dates are recorded in OCI.
Assets purchased under reverse repurchase agreements and sold under repurchase agreements
We purchase securities under agreements to resell (reverse repurchase agreements) and take possession of these securities. Reverse repurchase agreements are treated as collateralized lending transactions whereby we monitor the market value of the securities purchased and additional collateral is obtained when appropriate. We also have the right to liquidate the collateral held in the event of counterparty default. We also sell securities under agreements to repurchase (repurchase agreements), which are treated as collateralized borrowing transactions.
     Reverse repurchase agreements and repurchase agreements are carried on our Consolidated Balance Sheets at the amounts at which the securities were initially acquired or sold plus accrued interest, respectively, except when they are designated using the fair value option as held-for-trading and are recorded at fair value. Interest earned on reverse repurchase agreements is included in Interest income in our Consolidated Statements of Income, and interest incurred on repurchase agreements is included in Interest expenses in our Consolidated Statements of Income. Changes in fair value for reverse repurchase agreements and repurchase agreements carried at fair value under the fair value option are included in Trading revenue in Non-interest income.
     Prior to November 1, 2006, all reverse repurchase agreements and repurchase agreements were carried on our Consolidated Balance Sheets at the amounts at which the securities were initially acquired or sold, respectively, plus accrued interest on interest-bearing securities. Interest earned on reverse repurchase agreements was included in Interest income, and interest incurred on repurchase agreements was included in Interest expense, in our Consolidated Statements of Income.
Loans
Loans are recorded at amortized cost unless they have been designated as held-for-trading using the fair value option. Loans recorded at amortized cost are net of an Allowance for loan losses and unearned income which comprises unearned interest and unamortized loan fees. Loans designated as held-for-trading are carried at fair value. Prior to November 1, 2006, all loans were presented at amortized cost net of an Allowance for loan losses and unearned income.
     Loans stated at amortized cost are subject to periodic impairment review and are classified as impaired when, in management’s opinion, there is no longer reasonable assurance of the timely collection of the full amount of principal or interest. Whenever a payment is 90 days past due, loans other than credit card balances and loans guaranteed or insured by a Canadian government (federal or provincial) or a Canadian government agency (collectively “Canadian government”) are classified as impaired unless they are fully secured and collection efforts are reasonably expected to result in repayment of debt within 180 days past due. Credit card balances are written off when a payment is 180 days in arrears. Loans guaranteed by a Canadian government are classified as impaired when the loan is contractually 365 days in arrears. When a loan is identified as impaired, the accrual of interest is discontinued and any previously accrued but unpaid interest on the loan is charged to the Provision for credit losses. Interest received on impaired loans is credited to the Provision for credit losses. Impaired loans are returned to performing status when all past due amounts, including interest, have been collected, loan impairment charges have been reversed, and the credit quality has improved such that timely collection of principal and interest is reasonably assured.
     When an impaired loan is identified, the carrying amount of the loan is reduced to its estimated realizable amount, measured by discounting the expected future cash flows at the effective interest rate inherent in the loan. In subsequent periods, recoveries of amounts previously written off and any increase in the carrying value of the loan are credited to the Allowance for credit losses on our Consolidated Balance Sheets. Where a portion of a loan is written off and the remaining balance is restructured, the new loan is carried on an accrual basis when there is no longer any reasonable doubt regarding the collectibility of principal or interest, and payments are not 90 days past due.
     Assets acquired in respect of problem loans are recorded at their fair value less costs of disposition. Fair value is determined based on either current market value where available or discounted cash flows. Any excess of the carrying value of the loan over the recorded fair value of the assets acquired is recognized by a charge to the Provision for credit losses.
     Fees that relate to activities such as originating, restructuring or renegotiating loans are deferred and recognized as Interest income over the expected term of such loans using the effective interest method. Where there is reasonable expectation that a loan will result, commitment and standby fees are also recognized as Interest income over the expected term of the resulting loan using the effective interest method. Otherwise, such fees are recorded as Other liabilities and amortized to Non-interest income over the commitment or standby period.
Allowance for credit losses
The Allowance for credit losses is maintained at levels that management considers appropriate to cover estimated identified credit related losses in the portfolio as well as losses that have been incurred, but are not yet identifiable as at the balance sheet date. The allowance relates to on-balance sheet exposures, such as loans and acceptances, and off-balance sheet items such as letters of credit, guarantees and unfunded commitments.
     The allowance is increased by a charge to the Provision for credit losses and decreased by the amount of write-offs, net of recoveries. The Allowance for credit losses for on-balance sheet items is included as a reduction to assets, and the allowance relating to off-balance sheet items is included in Other liabilities.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  119

 

 

 
NOTE 1 SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES (continued)
     The allowance is determined based on management’s identification and evaluation of problem accounts on estimated losses that exist on the remaining portfolio, and on other factors including the composition and credit quality of the portfolio, and changes in economic and business conditions. The Allowance for credit losses consists of Specific allowances and the General allowance.
Specific allowances
Specific allowances are recorded to recognize estimated losses on both retail and wholesale loans that have become impaired. The losses relating to wholesale borrowers including small business loans individually managed are estimated using management’s judgment relating to the timing of future cash flow amounts that can be reasonably expected from the borrowers, financially responsible guarantors and the realization of collateral. The amounts expected to be recovered are reduced by estimated collection costs and discounted at the effective interest rate of the obligation. The losses relating to retail portfolios, including residential mortgages, and personal and small business loans managed on a pooled basis are based on net write-off experience. For credit cards, no specific allowance is maintained as balances are written off when a payment is 180 days in arrears. Personal loans are generally written off at 150 days past due. Write-offs for other loans are generally recorded when there is no realistic prospect of full recovery.
General allowance
A general allowance is established to cover estimated credit losses incurred in the lending portfolio that have not yet been specifically identified as impaired. For heterogeneous loans (wholesale loans including small business loans individually managed), the determination of the general allowance is based on the application of estimated probability of default, gross exposure at default and loss factors, which are determined by historical loss experience and delineated by loan type and rating. For homogeneous portfolios (retail loans) including residential mortgages, credit cards, as well as personal and small business loans that are managed on a pooled basis, the determination of the general allowance is based on the application of historical loss rates. In determining the general allowance level, management also considers the current portfolio credit quality trends, business and economic conditions, the impact of policy and process changes, and other supporting factors. In addition, the general allowance includes a component for the model limitations and imprecision inherent in the allowance methodologies.
Acceptances
Acceptances are short-term negotiable instruments issued by our clients to third parties which we guarantee. The potential liability under acceptances is reported in Liabilities — Other on our Consolidated Balance Sheets. The recourse against our clients in the case of a call on these commitments is reported as a corresponding asset of the same amount in Assets — Other. Fees earned are reported in Non-interest income.
Derivatives
Derivatives are primarily used in sales and trading activities. Derivatives are also used to manage our exposures to interest, currency, credit and other market risks. The most frequently used derivative products are interest rate swaps, interest rate futures, forward rate agreements, interest rate options, foreign exchange forward contracts, currency swaps, foreign currency futures, foreign currency options and credit derivatives. All derivative instruments are recorded on our Consolidated Balance Sheets at fair value, including those derivatives that are embedded in financial or non-financial contracts that are not closely related to the host contracts.
     When derivatives are used in sales and trading activities, the realized and unrealized gains and losses on derivatives are recognized in Non-interest income-Trading revenue. Derivatives with a positive fair value are reported as Derivative assets and derivatives with a negative fair value are reported as Derivative liabilities. Where we have both the legal right and intent to settle derivative assets and liabilities simultaneously with a counterparty, the net fair value of the derivative positions is reported as an asset or liability, as appropriate. Margin requirements and premiums paid are also included in Derivative assets, while premiums received are shown in Derivative liabilities.
     When derivatives are used to manage our own exposures, we determine for each derivative whether hedge accounting can be applied, as discussed below.
Hedge accounting
We use derivatives and non-derivatives in our hedging strategies to manage our exposure to interest, currency, credit and other market risks. Where hedge accounting can be applied, a hedge relationship is designated and documented at inception to detail the particular risk management objective and the strategy for undertaking the hedge transaction. The documentation identifies the specific asset, liability or anticipated cash flows being hedged, the risk that is being hedged, the type of hedging instrument used and how effectiveness will be assessed. The hedging instrument must be highly effective in accomplishing the objective of offsetting either changes in the fair value or anticipated cash flows attributable to the risk being hedged both at inception and throughout the life of the hedge. Hedge accounting is discontinued prospectively when it is determined that the hedging instrument is no longer effective as a hedge, the hedging instrument is terminated or sold, or upon the sale or early termination of the hedged item. Refer to Note 2 for the fair value of the derivatives and non-derivative financial instruments categorized by their hedging relationships, as well as derivatives that are not designated in hedging relationships.
Fair value hedges
In a fair value hedging relationship, the carrying value of the hedged item is adjusted for changes in fair value attributable to the hedged risk and recognized in Non-interest income. Changes in the fair value of the hedged item, to the extent that the hedging relationship is effective, are offset by changes in the fair value of the hedging derivative, which are also recognized in Non-interest income. When hedge accounting is discontinued, the carrying value of the hedged item is no longer adjusted and the cumulative fair value adjustments to the carrying value of the hedged items are amortized to Net income over the remaining term of the original hedging relationship.
     We predominantly use interest rate swaps to hedge our exposure to the changes in a fixed interest rate instrument’s fair value caused by changes in interest rates. We also use, in limited circumstances, certain cash instruments to hedge our exposure to the changes in fair value of monetary assets attributable to changes in foreign currency exchange rates.
Cash flow hedges
In a cash flow hedging relationship, the effective portion of the change in the fair value of the hedging derivative, net of taxes, is recognized in OCI while the ineffective portion is recognized in Non-interest income. When hedge accounting is discontinued, the amounts previously recognized in AOCI are reclassified to Net interest income during the periods when the variability in the cash flows of the hedged item affects Net interest income. Gains and losses on derivatives are reclassified immediately to Net income when the hedged item is sold or terminated early. We predominantly use interest rate swaps to hedge the variability in cash flows related to a variable rate asset or liability.
Royal Bank of Canada: Annual Report 2007
120  Consolidated Financial Statements

 

 

     Prior to November 1, 2006, when a derivative was designated and qualified as an effective hedging instrument in a fair value or cash flow hedge, the income or expense of that derivative was recognized as an adjustment to Interest income or Interest expense of the hedged item in the same period. When hedge accounting was discontinued prospectively, the fair value of the derivative was recognized in Derivative assets or liabilities at that time and the gain or loss was deferred and recognized in Net interest income in the periods in which the hedged item affects income. When hedge accounting was discontinued due to the sale or early termination of the hedged item, the fair value of the derivative was recognized in Derivative assets or liabilities at that time and the unrealized gain or loss is recognized in Non-interest income.
Net investment hedges
In hedging a foreign currency exposure of a net investment in a self-sustaining foreign operation, the effective portion of foreign exchange gains and losses on the hedging instruments, net of applicable taxes, is recognized in OCI and the ineffective portion is recognized in Non-interest income. The amounts previously recognized in AOCI are recognized in Net income when there is a reduction in the hedged net investment as a result of a dilution or sale of the net investment, or reduction in equity of the foreign operation as a result of dividend distributions.
     We use foreign exchange contracts and foreign currency-denominated liabilities to manage our foreign currency exposures to net investments in self-sustaining foreign operations having a functional currency other than the Canadian dollar.
     Prior to November 1, 2006, foreign exchange gains and losses on these hedging instruments, net of tax, were recorded in Net foreign currency translation adjustments in our Consolidated Statements of Changes in Shareholders’ Equity.
Premises and equipment
Premises and equipment are stated at cost less accumulated depreciation. Depreciation is recorded principally on a straight-line basis over the estimated useful lives of the assets, which are 25 to 50 years for buildings, 3 to 10 years for computer equipment, and 7 to 10 years for furniture, fixtures and other equipment. The amortization period for leasehold improvements is the lesser of the useful life of the leasehold improvements or the lease term plus the first renewal period, if reasonably assured of renewal, up to a maximum of 10 years. Gains and losses on disposal are recorded in Non-interest income.
Business combinations, goodwill and other intangibles
All business combinations are accounted for using the purchase method. Identifiable intangible assets are recognized separately from Goodwill and included in Other intangibles. Goodwill represents the excess of the price paid for the business acquired over the fair value of the net identifiable assets acquired, and is assigned to reporting units of a business segment. A reporting unit comprises business operations with similar economic characteristics and strategies, and is defined by GAAP as the level of reporting at which goodwill is tested for impairment and is either a business segment or one level below. Upon disposal of a portion of a reporting unit, goodwill is allocated to the disposed portion based on the fair value of that portion relative to the total reporting unit.
     Goodwill is evaluated for impairment annually as at August 1 or more often if events or circumstances indicate there may be an impairment. If the carrying value of a reporting unit, including the allocated goodwill, exceeds its fair value, goodwill impairment is measured as the excess of the carrying amount of the reporting unit’s allocated goodwill over the implied fair value of the goodwill, based on the fair value of the assets and liabilities of the reporting unit. Any goodwill impairment is charged to income in the period in which the impairment is identified. Subsequent reversals of impairment are prohibited.
     Other intangibles with a finite life are amortized on a straight-line basis over their estimated useful lives, generally not exceeding 20 years, and are also tested for impairment when conditions exist which may indicate that the estimated future net cash flows from the asset will be insufficient to recover its carrying amount.
Income taxes
We use the asset and liability method whereby income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets or liabilities for accounting purposes compared with tax purposes. A future income tax asset or liability is determined for each temporary difference based on the tax rates that are expected to be in effect when the underlying items of income and expense are expected to be realized, except for earnings related to our foreign operations where repatriation of such amounts is not contemplated in the foreseeable future. Income taxes reported in our Consolidated Statements of Income include the current and future portions of the expense. Income taxes applicable to items charged or credited to Shareholders’ equity are netted with such items. Changes in future income taxes related to a change in tax rates are recognized in the period when the tax rate change is substantively enacted.
     Net future income taxes accumulated as a result of temporary differences are included in Other assets. A valuation allowance is established to reduce future income tax assets to the amount more likely than not to be realized. In addition, our Consolidated Statements of Income contain items that are non-taxable or non-deductible for income tax purposes and, accordingly, cause the income tax provision to be different from what it would be if based on statutory rates.
Pensions and other post-employment benefits
We offer a number of benefit plans, which provide pension and other benefits to eligible employees (as described in Note 20). These plans include registered defined benefit pension plans, supplemental pension plans, defined contribution plans and health, dental, disability and life insurance plans.
     Investments held by the pension funds primarily comprise equity and fixed income securities. Pension fund assets are valued at fair value. For the principal defined benefit plans, the expected return on plan assets, which is reflected in the pension benefit expense, is calculated using a market-related value approach. Under this approach, assets are valued at an adjusted market value, whereby realized and unrealized capital gains and losses are amortized over three years on a straight-line basis. For the majority of the non-principal and supplemental defined benefit pension plans, the expected return on plan assets is calculated based on fair value of assets.
     Actuarial valuations for the defined benefit plans are performed on a regular basis to determine the present value of the accrued pension and other post-employment benefits, based on projections of employees’ compensation levels to the time of retirement and the costs of health, dental, disability and life insurance.
     Our defined benefit pension expense, which is included in Non-interest expenses — Human resources, consists of the cost of employee pension benefits for the current year’s service, interest cost on the liability, expected investment return on the market-related value or market value of plan assets and the amortization of prior service costs, net actuarial gains or losses and transitional assets or obligations. For some of our defined benefit plans, including the principal defined benefit plans, actuarial gains or losses are determined each year and amortized over the expected average remaining service life of employee groups covered by the plan. For the remaining defined benefit plans, net actuarial gains or losses in excess of the greater of 10% of the plan assets or the benefit obligation at the beginning of the year are amortized over the expected average remaining service life of employee groups covered by the plan.
     Gains and losses on settlements of defined benefit plans are recognized in income when settlement occurs. Curtailment gains and losses are recognized in the period when the curtailment becomes probable and the impact can be reasonably estimated.
     Our defined contribution plan expense is included in Non-interest expense-Human resources for services rendered by employees during the period.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  121

 

 

 
NOTE 1 SIGNIFICANT ACCOUNTING POLICIES AND ESTIMATES (continued)
     The cumulative excess of pension fund contributions over the amounts recorded as expenses is reported as a Prepaid pension benefit cost in Other assets. The cumulative excess of expense over fund contributions is reported as Accrued pension and other post-employment benefit expense in Other liabilities.
Stock-based compensation
We offer stock-based compensation plans to certain key employees and to our non-employee directors as described in Note 21.
     We use the fair value method to account for stock options granted to employees whereby compensation expense is recognized over the applicable vesting period with a corresponding increase in Contributed surplus. When the options are exercised, the exercise price proceeds together with the amount initially recorded in Contributed surplus are credited to Common shares. Stock options granted prior to November 1, 2002, were accounted for using the intrinsic value method, and accordingly no expense was recognized for these options since the exercise price for such grants was equal to the closing price on the day before the stock options were granted. These awards fully vested during 2006. When these stock options are exercised, the proceeds will be recorded as Common shares.
     Options granted between November 29, 1999, and June 5, 2001, were accompanied by tandem stock appreciation rights (SARs), which gave participants the option to receive cash payments equal to the excess of the current market price of our shares over the options’ exercise price. SARs obligations are now fully vested and give rise to compensation expense as a result of changes in the market price of our common shares. These expenses, net of related hedges, are recorded as Non-interest expense — Human resources in our Consolidated Statements of Income with a corresponding increase in Other liabilities on our Consolidated Balance Sheets.
     Our other compensation plans include performance deferred share plans and deferred share unit plans for key employees (the Plans). The deferred share plans are settled in our common shares or cash, and the deferred share unit plans are settled in cash. The obligations for the Plans are accrued over their vesting period. For share-settled awards, our accrued obligations are based on the market price of our common shares at the date of grant. For cash-settled awards, our accrued obligations are periodically adjusted for fluctuations in the market price of our common shares and dividends accrued. Changes in our obligations under the Plans, net of related hedges, are recorded as Non-interest expense — Human resources in our Consolidated Statements of Income with a corresponding increase in Other liabilities or Contributed surplus on our Consolidated Balance Sheets.
     The compensation cost attributable to options and awards, granted to employees who are eligible to retire or will become eligible to retire during the vesting period, is recognized immediately if the employee is eligible to retire on the grant date or over the period between the grant date and the date the employee becomes eligible to retire.
     Our contributions to the employee savings and share ownership plans are expensed as incurred.
Loan securitization
We periodically securitize loans by selling loans or packaged loans in the form of mortgage-backed securities (MBS) to independent special purpose entities (SPEs) or trusts that issue securities to investors. These transactions are accounted for as sales and the transferred assets are removed from our Consolidated Balance Sheets when we are deemed to have surrendered control over such assets and have received consideration other than beneficial interests in these transferred loans. For control to be surrendered, all of the following must occur: (i) the transferred loans must be isolated from the seller, even in bankruptcy or other receivership; (ii) the purchaser must have the legal right to sell or pledge the transferred loans or, if the purchaser is a Qualifying Special Purpose Entity (QSPE) as described in the CICA Accounting Guideline 12, Transfers of Receivables (AcG-12), its investors have the right to sell or pledge their ownership interest in the entity; and (iii) the seller must not continue to control the transferred loans through an agreement to repurchase them or have a right to cause the loans to be returned. If any one of these conditions is not met, the transfer is considered to be a secured borrowing, the loans remain on our Consolidated Balance Sheets, and the proceeds are recognized as a liability.
     When MBS are created, we reclassify the loans at their carrying costs into MBS and retained interests on our Consolidated Balance Sheets. The retained interest represents the excess spread of loan interest over the MBS rate of return. The initial carrying value of the MBS and the related retained interests are determined based on their relative fair value on the date of securitization. MBS are classified as trading account securities or available-for-sale securities, based on management’s intent. Retained interests are classified as available-for-sale. Both MBS and the retained interests are subject to periodic impairment review.
     Prior to November 1, 2006, retained interests in securitizations that could be contractually prepaid or otherwise settled in such a way that we would not recover substantially all of our recorded investment were classified as Investment account securities at amortized cost.
     Gains on the sale of loans or MBS are recognized in Non-interest income and are dependent on the previous carrying amount of the loans or MBS involved in the transfer. To obtain fair values, quoted market prices are used, if available. When quotes are not available for retained interests, we generally determine fair value based on the present value of expected future cash flows using management’s best estimates of key assumptions such as payment rates, weighted average life of the prepayable receivables, excess spread, expected credit losses and discount rates commensurate with the risks involved.
     For each securitization transaction where we have retained the servicing rights, we assess whether the benefits of servicing represent adequate compensation. When the benefits of servicing are more than adequate, a servicing asset is recognized in Other assets. When the benefits of servicing are not expected to be adequate, we recognize a servicing liability in Other liabilities. Neither an asset nor a liability is recognized when we have received adequate compensation. A servicing asset or liability is amortized in proportion to and over the period of estimated net servicing income.
Insurance
Premiums from long-duration contracts, primarily life insurance, are recognized when due in Non-interest income — Insurance premiums, investment and fee income. Premiums from short-duration contracts, primarily property and casualty, and fees for administrative services are recognized in Insurance premiums, investment and fee income over the related contract period. Unearned premiums of the short-duration contracts, representing the unexpired portion of premiums, are reported in Other liabilities. Investments made by our insurance operations are classified as available-for-sale or loans and receivables, except for investments supporting the policy benefit liabilities on life and health insurance contracts which are designated as held-for-trading under the fair value option with changes in fair value reported in Insurance premiums, investment and fee income.
     Insurance claims and policy benefit liabilities represent current claims and estimates for future insurance policy benefits. Liabilities for life insurance contracts are determined using the Canadian Asset Liability Method (CALM), which incorporates assumptions for mortality,
Royal Bank of Canada: Annual Report 2007
122  Consolidated Financial Statements

 

 

morbidity, policy lapses and surrenders, investment yields, policy dividends, operating and policy maintenance expenses, and provisions for adverse deviation. These assumptions are reviewed at least annually and updated in response to actual experience and market conditions. Liabilities for property and casualty insurance represent estimated provisions for reported and unreported claims. Liabilities for life and property and casualty insurance are included in Insurance claims and policy benefit liabilities.
     Acquisition costs for new insurance business consist of commissions, premium taxes, certain underwriting costs and other costs that vary with the acquisition of new business. Deferred acquisition costs for life insurance products are implicitly recognized in Insurance claims and policy benefit liabilities by CALM. For property and casualty insurance, these costs are classified as Other assets and amortized over the policy term.
     Segregated funds are lines of business in which we issue a contract where the benefit amount is directly linked to the market value of the investments held in the underlying fund. The contractual arrangement is such that the underlying assets are registered in our name but the segregated fund policyholders bear the risk and rewards of the fund’s investment performance. We provide minimum death benefit and maturity value guarantees on segregated funds. The liability associated with these minimum guarantees is recorded in Insurance claims and policy benefit liabilities. Segregated funds are not included in our Consolidated Financial Statements. We derive only fee income from segregated funds, which is reflected in Insurance premiums, investment and fee income. Fee income includes management fees, mortality, policy, administration and surrender charges.
     Prior to November 1, 2006, investments made by our insurance operations were included in Investment account securities. Realized gains and losses on disposal of fixed income investments that support life insurance liabilities were deferred and amortized to Insurance premiums, investment and fee income over the remaining term to maturity of the investments sold, up to a maximum period of 20 years. For equities that were held to support non-universal life insurance products, the realized gains and losses were deferred and amortized into Insurance premiums, investment and fee income at the quarterly rate of 5% of unamortized deferred gains and losses. The differences between the market value and adjusted carrying cost of these equities were reduced quarterly by 5%. Equities held to support universal life insurance products were carried at market value. Realized and unrealized gains or losses on these equities were included in Insurance premiums, investment and fee income. Specific investments were written down to market value or the net realizable value if it was determined that any impairment in value was other-than-temporary. The writedown was recorded against Insurance premiums, investment and fee income in the period the impairment is recognized.
Liabilities and equity
Financial instruments that will be settled by a variable number of our common shares upon their conversion by the holders as well as the related accrued distributions are classified as liabilities on our Consolidated Balance Sheets. Dividends and yield distributions on these instruments are classified as Interest expense in our Consolidated Statements of Income.
Earnings per share
Earnings per share is computed by dividing Net income available to common shareholders by the weighted average number of common shares outstanding for the period, net of Treasury shares. Net income available to common shareholders is determined after deducting dividend entitlements of preferred shareholders and any gain (loss) on redemption of preferred shares net of related income taxes. Diluted earnings per share reflects the potential dilution that could occur if additional common shares are assumed to be issued under securities or contracts that entitle their holders to obtain common shares in the future, to the extent such entitlement is not subject to unresolved contingencies. The number of additional shares for inclusion in diluted earnings per share calculations is determined using the treasury stock method. Under this method, stock options whose exercise price is less than the average market price of our common shares are assumed to be exercised and the proceeds are used to repurchase common shares at the average market price for the period. The incremental number of common shares issued under stock options and repurchased from proceeds is included in the calculation of diluted earnings per share.
Use of estimates and assumptions
In preparing our Consolidated Financial Statements in conformity with GAAP, management is required to make estimates and assumptions that affect the reported amounts of assets, liabilities, net income and related disclosures. Certain estimates, including the allowance for credit losses, the fair value of financial instruments, accounting for securitizations, litigation provisions, variable interest entities, insurance claims and policy benefit liabilities, pensions and other post-employment benefits, the carrying value of goodwill, credit card customer loyalty reward program liability and income taxes, require management to make subjective or complex judgments. Accordingly, actual results could differ from these and other estimates thereby impacting our Consolidated Financial Statements.
Change in accounting estimate
During the year, we adjusted the liability associated with our credit card customer loyalty reward program by $121 million in order to reflect higher program costs. This change in estimate is reflected as an increase in Other — Other liabilities on our Consolidated Balance Sheets and as a decrease in Non-interest income — Card service revenue in our Consolidated Statements of Income.
Change in financial statement presentation
On November 1, 2007, we implemented the International Convergence of Capital Measurement and Capital Standards: A Revised Framework, known as Basel II. In preparation for this implementation, we reclassified our loans and credit quality information as either Retail or Wholesale. During the year, we revisited our presentation of certain assets, liabilities, revenues and expenses for previous periods to better reflect the nature of these items. Accordingly, certain comparative amounts have been reclassified to conform with the current year’s presentation. These reclassifications did not materially impact our consolidated financial position or results of operations.
Future accounting changes
Capital Disclosures and Financial Instruments — Disclosures and Presentation
On December 1, 2006, the CICA issued three new accounting standards: Handbook Section 1535, Capital Disclosures (Section 1535), Handbook Section 3862, Financial Instruments — Disclosures (Section 3862), and Handbook Section 3863, Financial Instruments — Presentation (Section 3863). These new standards became effective for us on November 1, 2007.
     Section 1535 specifies the disclosure of (i) an entity’s objectives, policies and processes for managing capital; (ii) quantitative data about what the entity regards as capital; (iii) whether the entity has complied with any capital requirements; and (iv) if it has not complied, the consequences of such non-compliance.
     Sections 3862 and 3863 replace Handbook Section 3861, Financial Instruments — Disclosure and Presentation, revising and enhancing its disclosure requirements, and carrying forward unchanged its presentation requirements. These new sections place increased emphasis on disclosures about the nature and extent of risks arising from financial instruments and how the entity manages those risks.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  123

 

 

 
NOTE 2 FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair value of a financial instrument is the amount at which the financial instrument could be exchanged in an arm’s-length transaction between knowledgeable and willing parties under no compulsion to act. Fair values are determined by reference to quoted bid or ask prices, as appropriate, in the most advantageous active market for that instrument to which we have immediate access. Where bid and ask prices are unavailable, we use the closing price of the most recent transaction of that instrument subject to the liquidation adjustments referred to below. In the absence of an active market, we determine fair values based on prevailing market rates (bid and ask prices, as appropriate) for instruments with similar characteristics and risk profiles or internal or external valuation models, such as option pricing models and discounted cash flow analysis, using observable market-based inputs.
     Fair values determined using valuation models require the use of assumptions concerning the amount and timing of estimated future cash flows and discount rates. In determining those assumptions, we look primarily to external readily observable market inputs including factors such as interest rate yield curves, currency rates, and price and rate volatilities, as applicable. In limited circumstances, we use input parameters that are not based on observable market data with an adjustment to reflect the uncertainty and to ensure that financial instruments are reported at fair values. Based on our assessment we believe that using possible alternative assumptions to fair value such financial instruments will not result in significantly different fair values.
     Liquidity adjustments are calculated when market prices are not observable due to insufficient trading volume or a lack of recent trades in a less active or inactive market. Liquidity adjustments are also calculated to reflect the cost of unwinding a larger than normal market size risk position.
     All of our derivatives transactions are accounted for on a fair value basis. We record valuation adjustments that represent the fair value of the credit risk of our derivative portfolios. These adjustments take into account the creditworthiness of our counterparties, the current and potential future mark-to-market of the transactions, and the effects of credit mitigants such as master netting agreements and collateral agreements. Credit valuation adjustments are recalculated regularly for all of our derivative portfolios. Changes to credit valuation adjustments are recorded in current period income.
     We have documented internal policies that detail our processes for determining fair value, including the methodologies used in establishing our valuation adjustments. These methodologies are consistently applied and periodically reviewed by our Risk Management group.
Carrying value and fair value of selected financial instruments
As a result of adopting the new financial instruments accounting standards, certain financial instruments are now measured at fair value which were previously reported at cost or amortized cost. This is primarily due to the reclassification of certain securities as Trading securities, which includes securities designated as held-for-trading using the fair value option. The following table provides a comparison of carrying and fair values as at October 31, 2007 and October 31, 2006, for selected financial instruments:
                                                                         
 
                                                                    October 31,  
    October 31, 2007     2006  
                            Carrying                                
    Carrying value and fair value of     value     Fair value                          
    Financial                                                  
    instruments     Financial     Available-     Loans and     Loans and     Available-                    
    required to     instruments     for-sale     receivables     receivables     for-sale                    
    be classified     designated     instruments     and     and     instruments     Total     Total     Total  
    as held-     as held-     measured     non-trading     non-trading     measured     carrying     fair     fair  
    for-trading     for-trading     at fair value     liabilities     liabilities     at cost     amount     value     value  
 
Financial assets
                                                                        
Securities
                                                                        
Trading
   $ 129,408     $ 18,838     $ —     $ —     $ —     $ —     $ 148,246     $ 148,246          
Available-for-sale(1)
     —       —       28,811       —       —       1,198       30,009       30,009          
 
Total securities
   $ 129,408     $ 18,838     $ 28,811     $ —     $ —     $ 1,198     $ 178,255     $ 178,255     $ 185,239  
 
Assets purchased under reverse repurchase agreements and securities borrowed
   $ —     $ 25,522     $ —     $ 38,791     $ 38,791     $ —     $ 64,313     $ 64,313     $ 59,378  
 
Loans
                                                                        
Retail
   $ —     $ —     $ —     $ 168,782     $ 168,375     $ —     $ 168,782     $ 168,375          
Wholesale
     —       3,235       —       65,919       65,910       —       69,154       69,145          
 
Total loans
   $ —     $ 3,235     $ —     $ 234,701     $ 234,285     $ —     $ 237,936     $ 237,520     $ 208,638  
 
Other
                                                                        
Derivatives
   $ 66,585     $ —     $ —     $ —     $ —     $ —     $ 66,585     $ 66,585     $ 37,682  
Other assets
     —       164       —       24,653       24,653       —       24,817       24,817       22,660  
 
Financial liabilities
                                                                        
Deposits
                                                                        
Personal
   $ —     $ 851     $ —     $ 115,706     $ 115,609     $ —     $ 116,557     $ 116,460          
Business and government
     1,639       56,751       —       161,496       161,217       —       219,886       219,607          
Bank
     —       5,668       —       23,094       23,095       —       28,762       28,763          
 
Total deposits
   $ 1,639     $ 63,270     $ —     $ 300,296     $ 299,921     $ —     $ 365,205     $ 364,830     $ 343,312  
 
Other
                                                                        
Obligations related to securities sold short
   $ 44,689     $ —     $ —     $ —     $ —     $ —     $ 44,689     $ 44,689     $ 38,252  
Obligations related to assets sold under repurchase agreements and securities loaned
     —       24,086       —       12,947       12,947       —       37,033       37,033       41,103  
Derivatives
     72,010       —       —       —       —       —       72,010       72,010       42,108  
Other liabilities
     —       —       —       36,232       36,262       —       36,232       36,262       28,736  
Subordinated debentures
     —       77       —       6,158       6,427       —       6,235       6,504       7,384  
Trust capital securities
     —       —       —       1,400       1,476       —       1,400       1,476       1,532  
Preferred share liabilities
     —       —       —       300       300       —       300       300       304  
 
(1)   Available-for-sale securities, including loan substitutes, are carried at fair value and held-to-maturity securities are carried at amortized cost. Prior to November 1, 2006, both available-for-sale and held-to-maturity securities were classified as Investment securities and were carried at amortized cost. The prior period comparative amounts have not been restated.
Royal Bank of Canada: Annual Report 2007
124  Consolidated Financial Statements

 

 

The purpose of the table below is to present the carrying value of those financial instruments that were classified upon adoption as held-for-trading or available-for-sale or designated as held-for-trading using the fair value option.
                         
 
    October 31, 2006
    Carrying value
    Required                  
    to be     Designated     Classified  
    classified     as     as  
    as held-for-     held-for-     available-  
    trading     trading     for-sale  
 
Financial assets
                        
Securities
                        
Trading
   $ 139,491     $ 18,412     $ —  
Investments (1)
     —       —       26,966  
 
Total securities
   $ 139,491     $ 18,412     $ 26,966  
 
Assets purchased under reverse repurchase agreements and securities borrowed
   $ —     $ 40,535     $ —  
Loans
     —       2,686       —  
Other
                        
Derivatives
     37,733       —       —  
Other assets
     —       527       —  
 
Financial liabilities
                        
Deposits
   $ 1,651     $ 60,859     $ —  
Other
                        
Obligations related to securities sold short
     38,252       —       —  
Obligations related to assets sold under repurchase agreements and securities loaned
     —       27,494       —  
Derivatives
     42,340       —       —  
 
(1)   Includes the value of loan substitutes, which is nominal.
 
During the year, the fair value of our net financial assets classified as held-for-trading increased by $2,115 million. The fair value of our net financial assets designated as held-for-trading increased by $80 million; substantially all of this increase was economically hedged. The fair value of financial liabilities that we designated as held-for-trading decreased by $88 million due to changes in our own credit risk.
     The following table presents the carrying values of the derivative and non-derivative financial instruments designated as hedging instruments categorized by their hedging relationships, as well as derivatives that are not designated in hedging relationships.
                                 
 
    As at October 31, 2007  
 
    Designated as hedging instruments
in hedging relationships		     Not designated  
    Cash flow     Fair value     Net investment     in a hedging  
Derivatives and non-derivative financial instruments   hedges     hedges     hedges     relationship  
 
Financial assets
                                
Derivative financial instruments (1)
   $ 390     $ 268     $ 856     $ 65,071  
Financial liabilities
                                
Derivative financial instruments (1)
   $ 206     $ 166     $ 5     $ 71,633  
Non-derivative financial instruments (2)
     —       472       4,307       n.a.  
 
(1)   All derivative instruments are carried at fair value.
 
(2)   Non-derivative financial instruments are carried at amortized cost.
 
n.a.   not applicable
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  125

 

 

 
 NOTE 2 FAIR VALUE OF FINANCIAL INSTRUMENTS (continued)
The following table presents the changes in fair value of the financial liabilities designated as held-for-trading using the fair value option as well as their contractual maturity and carrying amounts.
                                 
 
    October 31, 2007  
                    Difference     Change in fair  
                    between     value since  
                    carrying     November 1, 2006  
                    amount and     attributable  
    Contractual           contractual     to changes  
    maturity     Carrying     maturity     in RBC’s  
Liabilities designated as held-for-trading   amount     amount     amount     credit spread  
 
Term deposits
                                
Personal
   $ 890     $ 851     $ (39 )   $ (6 )
Business and government
     56,741       56,751       10       (74 )
Bank 
     5,668       5,668       —       (1 )
 
Total term deposits
   $ 63,299     $ 63,270     $ (29 )   $ (81 )
 
Obligations related to assets sold under repurchase agreements and securities loaned
   $ 24,087     $ 24,086     $ (1 )   $ —  
Subordinated debentures
     82       77       (5 )   $ (7 )
 
Total
   $ 87,468     $ 87,433     $ (35 )   $ (88 )
 
The following table presents information on loans and receivables designated as held-for-trading using the fair value option, the maximum exposure to credit risk, the extent to which the risk is mitigated by credit derivatives and similar instruments, and changes in the fair value of these assets as at October 31, 2007:
                                                         
 
                                                    Cumulative
change		  
                                            Change in     in fair  
                    Change     Cumulative             fair value     value of credit  
    Carrying             in fair     change in     Extent to     of credit     derivatives  
    amount of             value since     fair value     which credit     derivatives     or similar  
    loans and             November 1,     since initial     derivatives     or similar     instruments  
    receivables             2006     recognition     or similar     instruments     since  
Loans and receivables   designated     Maximum     attributable     attributable to     instruments     since     designation  
designated as held-for-    as held-     exposure to     to changes in     changes in     mitigate     November 1,     of asset  
trading   for-trading     credit risk     credit risk     credit risk     credit risk     2006     at fair value  
 
Interest-bearing deposits with banks
   $ 4,821     $ 4,821     $ —     $ —     $ —     $ —     $ —  
Assets purchased under reverse repurchase agreements and securities borrowed
     25,522       25,522       —       —       —       —       —  
Loans
     3,235       3,164       (42 )     (21 )     1,106       18       —  
 
Total
   $ 33,578     $ 33,507     $ (42 )   $ (21 )   $ 1,106     $ 18     $ —  
 
Royal Bank of Canada: Annual Report 2007
126  Consolidated Financial Statements

 

 

NOTE 3 SECURITIES (1)
                                                                         
 
    Term to maturity  (2)              
                                            With no                    
    Within 3     3 months     1 to 5     Over 5 years     Over     specific     2007     2006     2005  
    months     to 1 year     years     to 10 years     10 years     maturity     Total     Total     Total  
Trading account
                                                                        
Canadian government debt
   $ 1,683     $ 3,046     $ 5,106     $ 1,383     $ 2,853     $ —     $ 14,071     $ 13,900     $ 11,814  
U.S. government debt
     384       1,066       2,084       377       5,106       —       9,017       7,793       7,281  
Other OECD government debt (3)
     —       1,429       2,699       26       82       —       4,236       4,658       6,476  
Mortgage-backed securities
     110       59       1,200       1,176       3,099       —       5,644       3,841       2,281  
Asset-backed securities
     231       47       6,612       53       691       —       7,634       9,064       8,781  
Corporate debt and other debt
                                                                        
Bankers’ acceptances
     373       1       —       —       —       —       374       766       998  
Certificates of deposit
     704       3,525       344       125       14       —       4,712       5,245       8,705  
Other
     5,189       4,011       24,468       2,220       4,986       1,564       42,438       44,139       33,714  
Equities
     —       —       —       —       —       60,120       60,120       57,831       45,710  
 
 
     8,674       13,184       42,513       5,360       16,831       61,684       148,246       147,237       125,760  
 
Available-for-sale securities (1)
                                                                        
Canadian government debt
                                                                        
Federal
                                                                        
Amortized cost
     195       57       2,031       382       —       —       2,665       3,649       6,214  
Fair value
     195       57       2,040       384       —       —       2,676       3,677       6,205  
Yield (4)
     3.5%     4.7%     4.4%     4.5%     —       —       4.4%     4.2%     3.6%
Provincial and municipal
                                                                        
Amortized cost
     —       —       201       78       —       —       279       1,687       2,035  
Fair value
     —       —       201       77       —       —       278       1,935       2,229  
Yield (4)
     —       —       4.0%     4.5%     —       —       4.2%     5.4%     4.9%
U.S. government debt
                                                                        
Federal
                                                                        
Amortized cost
     —       —       —       —       —       —       —       536       633  
Fair value
     —       —       —       —       —       —       —       508       628  
Yield (4)
     —       —       —       —       —       —       —       4.5%     2.2%
State, municipal and agencies
                                                                        
Amortized cost
     307       517       1,194       21       —       —       2,039       1,678       2,199  
Fair value
     307       518       1,155       21       —       —       2,001       1,648       2,139  
Yield (4)
     5.3%     5.1%     5.0%     5.6%     —       —       5.1%     3.6%     2.5%
Other OECD government debt (3)
                                                                        
Amortized cost
     1       622       107       84       5       —       819       758       1,595  
Fair value
     1       622       107       83       5       —       818       761       1,599  
Yield (4)
     3.6%     .5%     4.2%     4.6%     4.9%     —       1.4%     2.6%     1.9%
Mortgage-backed securities
                                                                        
Amortized cost
     80       90       4,854       405       3,573       —       9,002       11,805       8,254  
Fair value
     80       90       4,872       408       3,522       —       8,972       11,692       8,183  
Yield (4)
     5.2%     4.7%     4.6%     5.2%     5.0%     —       4.8%     4.5%     4.4%
Asset-backed securities
                                                                        
Amortized cost
     399       5       245       357       998       —       2,004       3,164       1,442  
Fair value
     399       5       239       357       939       —       1,939       3,171       1,445  
Yield (4)
     6.0%     4.2%     4.7%     5.2%     5.3%     —       5.4%     5.0%     4.2%
Corporate debt and other debt
                                                                        
Amortized cost
     2,563       2,779       3,229       774       505       —       9,850       11,162       10,676  
Fair value
     2,554       2,850       3,135       760       495       —       9,794       11,360       10,839  
Yield (4)
     4.8%     5.2%     4.5%     5.2%     4.4%     —       4.8%     4.8%     3.7%
Equities (5)
                                                                        
Cost
     —       —       —       —       —       2,715       2,715       2,537       1,012  
Fair value
     —       —       —       —       —       2,874       2,874       2,592       974  
Loan substitute
                                                                        
Cost
     —       —       —       —       400       256       656       656       675  
Fair value
     —       —       —       —       400       252       652       658       683  
Yield (4)
     —       —       —       —       4.6%     5.3%     4.9%     4.8%     3.7%
 
Amortized cost
     3,545       4,070       11,861       2,101       5,481       2,971       30,029       37,632       34,735  
Fair value
     3,536       4,142       11,749       2,090       5,361       3,126       30,004       38,002       34,924  
 
Held-to-maturity securities (1)
                                                                        
Amortized cost
     —       3       —       —       2       —       5       —       —  
Fair value
     —       3       —       —       2       —       5       —       —  
 
Total carrying value of securities (1)
   $ 12,210     $ 17,329     $ 54,262     $ 7,450     $ 22,194     $ 64,810     $ 178,255     $ 184,869     $ 160,495  
 
(1)   Available-for-sale securities, including loan substitutes, are carried at fair value and held-to-maturity securities are carried at amortized cost. Prior to November 1, 2006, both available-for-sale and held-to-maturity securities were classified as Investment securities and were carried at amortized cost. The prior period comparative amounts have not been restated.
 
(2)   Actual maturities may differ from contractual maturities shown above, since borrowers may have the right to prepay obligations with or without prepayment penalties.
 
(3)   OECD stands for Organisation for Economic Co-operation and Development.
 
(4)   The weighted average yield is based on the carrying value at the end of the year for the respective securities.
 
(5)   Includes the value of the shares received upon the restructuring of Visa Inc. Refer to Note 30.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  127

 

 

NOTE 3 SECURITIES (continued)
                                     
Unrealized gains and losses on Available-for-sale securities (1), (2)
                                                                 
 
    2007   2006
            Gross     Gross                     Gross     Gross          
    Amortized     unrealized     unrealized     Fair     Amortized     unrealized     unrealized     Fair    
    cost     gains     losses     value     cost     gains     losses     value    
 
Canadian government debt
                                                                  
Federal
   $ 2,665     $ 12     $ (1 )   $ 2,676     $ 3,649     $ 29     $ (1 )   $ 3,677    
Provincial and municipal
     279       —       (1 )     278       1,687       248       —       1,935    
U.S. government debt
                                                                  
Federal
     —       —       —       —       536       —       (28 )     508    
State, municipal and agencies
     2,039       10       (48 )     2,001       1,678       5       (35 )     1,648    
Other OECD government debt
     819       1       (2 )     818       758       4       (1 )     761    
Mortgage-backed securities
     9,002       30       (60 )     8,972       11,805       17       (130 )     11,692    
Asset-backed securities
     2,004       2       (67 )     1,939       3,164       11       (4 )     3,171    
Corporate debt and other debt
     9,855       45       (101 )     9,799       11,162       238       (40 )     11,360    
Equities
     2,715       191       (32 )     2,874       2,537       110       (55 )     2,592    
Loan substitute securities
     656       —       (4 )     652       656       2       —       658    
 
 
   $ 30,034     $ 291     $ (316 )   $ 30,009     $ 37,632     $ 664     $ (294 )   $ 38,002    
 
(1)   Available-for-sale securities, including loan substitutes, are carried at fair value and held-to-maturity securities are carried at amortized cost. Prior to November 1, 2006, both available-for-sale and held-to-maturity securities were classified as Investment securities and were carried at amortized cost. The prior period comparative amounts have not been restated.
 
(2)   Includes $5 million held-to-maturity securities.
Realized gains and losses on sale of Available-for-sale securities (1)
                         
 
    2007     2006     2005  
 
Realized gains
   $ 187     $ 177     $ 141  
Realized losses and writedowns
     (124 )     (89 )     (56 )
 
Net gain on sale of Available-for-sale securities
   $ 63     $ 88     $ 85  
 
(1)   Available-for-sale securities, including loan substitutes, are carried at fair value and held-to-maturity securities are carried at amortized cost. Prior to November 1, 2006, both available- for-sale and held-to-maturity securities were classified as Investment securities and were carried at amortized cost. The prior period comparative amounts have not been restated.
Fair value and unrealized losses position for Available-for-sale securities as at October 31, 2007
                                                 
 
    Less than 12 months     12 months or more     Total  
    Fair value     Unrealized losses     Fair value     Unrealized losses     Fair value     Unrealized losses
 
Canadian government debt
                                                
Federal
   $ 1,231     $ 1     $ —     $ —     $ 1,231     $ 1  
Provincial and municipal
     210       1       —       —       210       1  
U.S. government debt
                                                
Federal
     —       —       —       —       —       —  
State, municipal and agencies
     —       —       265       48       265       48  
Other OECD government debt
     47       2       —       —       47       2  
Mortgage-backed securities
     941       14       994       46       1,935       60  
Asset-backed securities
     853       5       501       62       1,354       67  
Corporate debt and other debt
     2,162       57       434       48       2,596       105  
Equities
     432       30       3       2       435       32  
 
Total temporarily impaired securities
   $ 5,876     $ 110     $ 2,197       $206     $ 8,073     $ 316  
 
The unrealized losses for Canadian government debt and U.S. government debt were caused by increases in interest rates and appreciation of the Canadian dollar against the U.S. dollar. The contractual terms of some of these investments either do not permit the issuer to settle the securities at a price less than the amortized cost of the investment, or permit prepayment of contractual amounts owing only with prepayment penalties assessed to recover interest foregone. As a result, it is not expected that these investments would be settled at a price less than the amortized cost. Further, a substantial amount of the U.S. dollar-denominated debt is hedged against the foreign currency risk and accordingly, the unrealized losses are not considered to be other-than-temporarily impaired as at October 31, 2007.
     Unrealized losses for mortgage-backed securities, asset-backed securities, corporate debt and other debt were due to interest rate changes and widening credit spreads caused by the recent disruption in the financial markets, the weakening of the U.S. housing market, credit rating downgrades of certain securities in the marketplace, and appreciation of the Canadian dollar against the U.S. dollar. However, given that a substantial portion of these securities are investment-grade securities and we have the ability and intent to hold these investments until there is a recovery of fair value, which may be at maturity, we believe it is probable that we will be able to collect the principal amount of these securities according to the contractual terms of the investments. Accordingly, we do not consider these investments to be other-than-temporarily impaired as at October 31, 2007.
     Unrealized losses on equity securities are primarily due to the timing of the market prices, foreign exchange movements, or the early years in the business cycle of the investees for certain investments. We do not consider these investments to be other-than-temporarily impaired as at October 31, 2007, as we have the ability and intent to hold them for a reasonable period of time until they recover their fair value.
Royal Bank of Canada: Annual Report 2007
128   Consolidated Financial Statements

 

 

The following table presents interest and dividends on Available-for-sale and Held-to-maturity securities:
Interest and dividends on Available-for-sale and Held-to-maturity securities (1)
                         
 
    2007     2006     2005  
 
Taxable interest income
   $ 968     $ 1,087     $ 862  
Non-taxable interest income
     2       2       2  
Dividends
     74       44       31  
 
 
   $ 1,044     $ 1,133     $ 895  
 
(1)   Available-for-sale securities, including loan substitutes, are carried at fair value and held-to-maturity securities are carried at amortized cost. Prior to November 1, 2006, both available-for-sale and held-to-maturity securities were classified as Investment securities and were carried at amortized cost. The prior period comparative amounts have not been restated.
NOTE 4 LOANS
                                                                 
 
    2007     2006  
                    Other                             Other        
    Canada     United States     International     Total     Canada     United States     International     Total  
 
Retail (1)
                                                                
Residential mortgages
   $ 107,453     $ 1,402     $ 890     $ 109,745     $ 94,272     $ 1,518     $ 885     $ 96,675  
Personal
     42,506       5,283       954       48,743       37,946       6,011       945       44,902  
Credit cards
     8,142       119       61       8,322       6,966       123       66       7,155  
Small business (2)
     2,652       —       —       2,652       2,318       —       —       2,318  
 
 
     160,753       6,804       1,905       169,462       141,502       7,652       1,896       151,050  
 
Wholesale (1)
                                                                
Business (3), (4)
     39,877       17,741       6,239       63,857       35,245       13,611       5,894       54,750  
Bank
     3,114       686       1,547       5,347       2,031       236       985       3,252  
Sovereign (5)
     416       —       347       763       553       —       334       887  
 
 
     43,407       18,427       8,133       69,967       37,829       13,847       7,213       58,889  
 
Total loans (6)
     204,160       25,231       10,038       239,429       179,331       21,499       9,109       209,939  
Allowance for loan losses
     (1,101 )     (321 )     (71 )     (1,493 )     (1,086 )     (266 )     (57 )     (1,409 )
 
Total loans net of allowance for loan losses
   $ 203,059     $ 24,910     $ 9,967     $ 237,936     $ 178,245     $ 21,233     $ 9,052     $ 208,530  
 
(1)   Geographic information is based on residence of borrower.
 
(2)   Includes small business exposure managed on a pooled basis.
 
(3)   Includes small business exposure managed on an individual client basis.
 
(4)   Included under Canada for 2007 are loans totalling $1,202 million to a variable interest entity administered by us.
 
(5)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
 
(6)   Loans are net of unearned income of $113 million (2006 — $62 million).
Loan maturities and rate sensitivity
                                                                 
 
    Maturity term (1)     Rate sensitivity  
    Under     1 to 5     Over                     Fixed     Non-rate-        
As at October 31, 2007   1 year     years     5 years (2)     Total     Floating     rate     sensitive     Total  
 
Retail
   $ 63,737     $ 92,337     $ 13,388     $ 169,462     $ 66,256     $ 101,496     $ 1,710     $ 169,462  
Wholesale
     39,908       22,269       7,790       69,967       48,625       21,342       —       69,967  
 
Total loans
   $ 103,645     $ 114,606     $ 21,178     $ 239,429     $ 114,881     $ 122,838     $ 1,710     $ 239,429  
Allowance for loan losses
     —       —       —       (1,493 )     —       —       —       (1,493 )
 
Total loans net of allowance for loan losses
   $ 103,645     $ 114,606     $ 21,178     $ 237,936     $ 114,881     $ 122,838     $ 1,710     $ 237,936  
 
(1)   Based on the earlier of contractual repricing or maturity date.
 
(2)   Included in Wholesale are loans totalling $1,202 million to a variable interest entity administered by us, with maturity terms exceeding five years.
Impaired loans (1),(2)
                                 
 
    2007 2006
            Specific              
    Gross     allowances     Net     Net  
 
Retail
                                
Residential mortgages
   $ 210     $ (23 )   $ 187     $ 152  
Personal
     189       (96 )     93       104  
Small business (3)
     19       (9 )     10       4  
 
 
   $ 418     $ (128 )   $ 290     $ 260  
 
Wholesale
                                
Business (4)
   $ 722     $ (223 )   $ 499     $ 311  
Bank
     —       —       —       —  
Sovereign (5)
     —       —       —       —  
 
 
   $ 722     $ (223 )   $ 499     $ 311  
 
Total
   $ 1,140     $ (351 )   $ 789     $ 571  
 
(1)   There are $353 million (2006 — $305 million) of loans that are contractually 90 days past due but are not considered impaired.
 
(2)   Average balance of gross impaired loans was $959 million (2006 — $805 million).
 
(3)   Includes small business exposure managed on a pooled basis.
 
(4)   Includes small business exposure managed on an individual client basis.
 
(5)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  129

 

NOTE 4 LOANS (continued)
Allowance for loan losses
                                                         
 
    2007 2006  
    Balance at                     Provision     Other     Balance     Balance  
    beginning                     for credit     adjustments     at end     at end  
    of year     Write-offs     Recoveries     losses     (1)     of year     of year  
 
Retail
                                                        
Residential mortgages
   $ 13     $ (5 )   $ 1     $ 13     $ 1     $ 23     $ 13  
Personal
     101       (444 )     74       364       1       96       101  
Credit cards
     —       (268 )     46       223       (1 )     —       —  
Small business (2)
     9       (42 )     7       34       1       9       9  
 
 
     123       (759 )     128       634       2       128     $ 123  
 
Wholesale
                                                        
Business (3)
   $ 140     $ (109 )   $ 42     $ 148     $ 2     $ 223     $ 140  
Bank
     —       —       —       —       —       —       —  
Sovereign (4)
     —       —       —       —       —       —       —  
 
Specific allowances
   $ 263     $ (868 )   $ 170     $ 782     $ 4     $ 351     $ 263  
General allowance (5)
     1,223       —       —       9       (11 )     1,221       1,223  
 
Total allowance for credit losses
   $ 1,486     $ (868 )   $ 170     $ 791     $ (7 )   $ 1,572     $ 1,486  
Allowance for off-balance sheet and other items (6)
     (77 )     —       —       (2 )     —       (79 )     —  
 
Total allowance for loan losses
   $ 1,409     $ (868 )   $ 170     $ 789     $ (7 )   $ 1,493     $ 1,486  
 
(1)   Primarily represent the translation impact of foreign currency-denominated allowance for loan losses.
 
(2)   Includes small business exposure managed on a pooled basis.
 
(3)   Includes small business exposure managed on an individual client basis.
 
(4)   Sovereign refers to all central governments and agencies, central banks, as well as other qualifying public sector entities and multilateral development banks.
 
(5)   Includes $79 million (2006 — $77 million) related to off-balance sheet and other items.
 
(6)   The allowance for off-balance sheet and other items is reported separately under Other liabilities.
During the year ended October 31, 2007, assets acquired in respect of problem loans amounted to $36 million (2006 — $9 million).
Net interest income after provision for credit losses
                         
 
    2007     2006     2005  
 
Net interest income
   $ 7,532     $ 6,796     $ 6,793  
Provision for credit losses
     791       429       455  
 
Net interest income after provision for credit losses
   $ 6,741     $ 6,367     $ 6,338  
 
NOTE 5 SECURITIZATIONS
The following table summarizes our securitization activities for 2007, 2006 and 2005:
                                                                 
 
    2007 (1)     2006     2005  
 
    Canadian                     Canadian                     Canadian        
    residential     Commercial     Credit     residential     Commercial     Credit     residential     Commercial  
    mortgage     mortgage     card     mortgage     mortgage     card     mortgage     mortgage  
    loans (2),(3)     loans (4)     loans (5)     loans (2),(3)     loans     loans (5)     loans (2),(3)     loans  
 
Securitized and sold
   $ 6,188     $ 1,937     $ 1,200     $ 6,329     $ 718     $ 1,200     $ 3,752     $ 655  
Net cash proceeds received
     6,097       1,876       400       6,210       729       600       3,739       667  
Asset-backed securities purchased
     —       47       794       —       —       596       —       —  
Retained rights to future excess interest
     146       —       9       121       —       8       100       —  
Pre-tax gain (loss) on sale
     55       (14 )     3       2       11       4       87       12  
 
(1)   We did not securitize any credit card loans during the year.
 
(2)   All Canadian residential mortgage loans securitized are insured.
 
(3)   Canadian insured residential mortgage loans securitized during the year through the creation of mortgage-backed securities and retained as at October 31, 2007 were $3,110 million (2006 – $4,869 million, 2005 – $1,050 million). These securities are carried at fair value; prior to November 1, 2006, these securities were carried at amortized cost.
 
(4)   The net cash proceeds received represent gross proceeds of $1,923 million less funds used to purchase notes of $47 million (principal value of $48 million). We did not purchase any notes as part of our securitization activities in 2006 or 2005.
 
(5)   The net cash proceeds received represent gross proceeds of $1,200 million in 2006 (2005 — $1,200 million) less funds used to purchase notes issued by Golden Credit Card Trust with a principal value of $800 million in 2006 (2005 — $600 million).
In addition to the above securitization transactions, we sold $815 million of residential mortgage loans in 2006, resulting in a pre-tax loss of $3 million. None were sold in 2007.
Royal Bank of Canada: Annual Report 2007
130  Consolidated Financial Statements

 

Cash flows from securitizations (1)
                                                                         
 
    2007     2006     2005  
 
    Credit     Canadian residential
mortgage		     Credit     Canadian residential
mortgage		     Credit     Canadian residential
mortgage		  
    card     loans     card     loans     card     loans  
    loans     Variable rate     Fixed rate     loans     Variable rate     Fixed rate     loans     Variable rate     Fixed rate  
 
Proceeds reinvested in
revolving securitizations
   $ 15,684     $ 1,043     $ 3,559     $ 17,107     $ 466     $ 2,251     $ 12,076     $ 419     $ 1,520  
Cash flows from excess spread (2)
     256       66       168       263       11       134       242       3       100  
 
(1)   This analysis is not applicable for commercial mortgage loans securitizations as we have not retained rights to future excess spread in these transactions.
 
(2)   Includes servicing fees received.
The key assumptions used to value the retained interests at the date of the securitization activities are as follows:
Key assumptions (1), (2)
                                                                 
    2007 (3)     2006     2005  
    Canadian residential     Credit     Canadian residential     Credit     Canadian residential  
    mortgage loans     card     mortgage loans     card     mortgage loans  
    Variable rate     Fixed rate     loans     Variable rate     Fixed rate     loans     Variable rate     Fixed rate  
 
Expected weighted average life of prepayable receivables (in years)
     2.63       3.69       .16       2.61       3.60       .15       3.48       3.59  
Payment rate
     29.20 %     14.38 %     40.02 %     30.00 %     15.39 %     40.06 %     13.52 %     13.36 %
Excess spread, net of credit losses
     .88       .83       5.13       1.18       .99       6.88       .20       1.06  
Expected credit losses
     —       —       2.15       —       —       1.75       —       —  
Discount rate
     4.71 %     4.80 %     10.00       4.32       4.36       10.00       3.64       3.59  
 
(1)   All rates are annualized except the payment rate for credit card loans which is monthly.
 
(2)   This analysis is not applicable for commercial mortgage loans securitizations as we have not retained rights to future excess spread in these transactions.
 
(3)   We did not securitize any credit card loans during the year.
     Static pool credit losses include actual incurred and projected credit losses divided by the original balance of the loans securitized. The expected static pool credit loss ratio for securitized credit card loans at October 31, 2007 was .52%. Static credit pool losses are not applicable to residential mortgages as substantially all the mortgages are government guaranteed.
     The following table summarizes the loan principal, past due and net write-offs for total loans reported on our Consolidated Balance Sheets and securitized loans that we manage as at October 31, 2007 and 2006:
Loans managed
                                                 
 
    2007     2006  
    Loan principal     Past due(1)     Net write-offs     Loan principal     Past due (1)     Net write-offs  
 
Retail
   $ 192,633     $ 754     $ 718     $ 172,118     $ 654     $ 597  
Wholesale
     69,967       739       66       58,889       485       (4 )
 
Total loans managed (2)
     262,600       1,493       784       231,007       1,139       593  
Less: Loans securitized and managed
                                               
Credit card loans
     3,650       —       86       3,650       —       85  
Canadian residential mortgage-backed securities created and sold
     14,239       —       —       12,186       —       —  
Canadian residential mortgage-backed securities created and retained
     5,282       —       —       5,232       —       —  
 
Total loans reported on the Consolidated Balance Sheets
   $ 239,429     $ 1,493     $ 698     $ 209,939     $ 1,139     $ 508  
 
(1)   Includes impaired loans as well as loans that are contractually 90 days past due but are not considered impaired.
 
(2)   Excludes any assets we have temporarily acquired with the intent at acquisition to sell to SPEs.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  131

 

 
NOTE 5 SECURITIZATIONS (continued)
     Key assumptions are used to determine the fair value of our retained interests. The following table is a summary of the key assumptions used as at October 31, 2007 and the sensitivity of the current fair value of our retained interests to immediate 10% and 20% adverse changes in these key assumptions.
Sensitivity of key assumptions
Increase (decrease) in fair value of retained interests due to adverse changes in key assumptions (1), (2)
                         
 
    2007  
    Credit     Canadian residential  
    card     mortgage loans  
    loans     Variable rate     Fixed rate  
 
Fair value of retained interests
   $ 27.5     $ 27.9     $ 386.7  
Weighted average remaining service life (in years)
     .25       2.63-3.27       3.05-3.97  
Payment rate
     37.39 %     29.20-40.00 %     9.25-18.00 %
Impact on fair value of 10% adverse change
   $ (1.6 )   $ (.8 )   $ (9.4 )
Impact on fair value of 20% adverse change
     (3.2 )     (1.5 )     (18.6 )
 
Excess spread, net of credit losses
     5.72 %     .68-.88 %     .84-.89 %
Impact on fair value of 10% adverse change
   $ (5.0 )   $ (14.0 )   $ (37.1 )
Impact on fair value of 20% adverse change
     (10.0 )     (28.0 )     74.3  
 
Expected credit losses
     2.18 %     — %     — %
Impact on fair value of 10% adverse change
   $ (1.2 )   $ —     $ —  
Impact on fair value of 20% adverse change
     (2.3 )     —       —  
 
Discount rate
     10.00 %     4.71-6.81 %     4.69-4.71 %
Impact on fair value of 10% adverse change
   $ —     $ (.2 )   $ (2.3 )
Impact on fair value of 20% adverse change
     (.1 )     (.3 )     (4.5 )
 
(1)   All rates are annualized except for the credit card loans payment rate which is monthly.
 
(2)   This analysis is not applicable for commercial mortgage loans securitizations as we have not retained rights to future excess spread in these transactions.
These sensitivities are hypothetical and should be used with caution. Changes in fair value based on a variation in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value may not be linear. The effect of a variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumptions. Generally, the changes in one factor may result in changes in another, which may magnify or counteract the sensitivity.
 
NOTE 6 VARIABLE INTEREST ENTITIES (VIEs)
The following table provides information about VIEs as at October 31, 2007 and 2006, in which we have significant variable interests, and those we consolidate under CICA Accounting Guideline 15, Consolidation of Variable Interest Entities (AcG-15), because we are the Primary Beneficiary.
                                 
 
            Maximum exposure             Maximum exposure  
    Total assets as at     to loss as at     Total assets as at     to loss as at  
    October 31, 2007     October 31, 2007     October 31, 2006     October 31, 2006  
 
Unconsolidated VIEs in which we have significant variable interests (1):
Multi-seller conduits (2)
   $ 41,785     $ 42,912     $ 34,258     $ 35,031  
Third-party conduits
     4,264       1,625       2,697       1,018  
Credit investment product VIEs
     2,676       1,733       —       —  
Investment funds
     1,517       324       3,390       303  
Structured finance VIEs
     407       407       2,592       1,465  
Other
     60       80       128       84  
 
 
   $ 50,709     $ 47,081     $ 43,065     $ 37,901  
 
Consolidated VIEs (3), (4):
                                
Investment funds (5)
   $ 995             $ 1,851          
Structured finance VIEs
     560               409          
Credit investment product VIEs
     276               689          
Compensation vehicles
     83               355          
Other
     144               151          
 
 
   $ 2,058             $ 3,455          
 
(1)   The maximum exposure to loss resulting from our significant variable interests in these VIEs consists mostly of investments, loans, liquidity facilities and fair value of derivatives. We have recognized $2,165 million (2006–$2,130 million) of this exposure on our Consolidated Balance Sheets.
 
(2)   Total assets represent maximum assets that may have to be purchased by the conduits under purchase commitments outstanding as at October 31, 2007. Actual assets held by these conduits as at October 31, 2007, were $29,290 million (2006—$24,811 million).
 
(3)   The assets that support the obligations of the consolidated VIEs are reported on our Consolidated Balance Sheets primarily as follows: Interest-bearing deposits with banks of $75 million (2006—$120 million), Trading securities of $1,185 million (2006—$2,483 million), Available-for-sale securities of $315 million (2006—$409 million) and Other assets of $401 million (2006—$287 million). The compensation vehicles hold $83 million (2006—$156 million) of our common shares, which are reported as Treasury shares. The obligation to provide common shares to employees is recorded as an increase to Contributed surplus as the expense for the corresponding stock-based compensation plan is recognized.
 
(4)   Investors have recourse only to the assets of the related VIEs and do not have recourse to our general assets unless we breach our contractual obligations relating to those VIEs, provide liquidity facilities or credit enhancement facilities to, or enter into derivative transactions with, the VIEs.
 
(5)   The implementation of EIC-163 (refer to Note 1) resulted in the deconsolidation of certain investment funds during 2007. As at October 31, 2006, the total assets and maximum exposure to loss of these deconsolidated funds were $363 million and $36 million, respectively.
Royal Bank of Canada: Annual Report 2007
132   Consolidated Financial Statements

 

 

Multi-seller and third-party conduits
We administer seven multi-seller asset-backed commercial paper conduit programs (multi-seller conduits). These conduits primarily purchase financial assets from clients and finance those purchases by issuing asset-backed commercial paper. Our clients primarily utilize multi-seller conduits to diversify their financing sources and to reduce funding costs.
     The multi-seller conduits also finance assets that are either in the form of securities, including Collateralized Debt Obligations, or instruments that closely resemble securities such as credit-linked notes. In these situations, the multi-seller conduit is often one of many investors in the securities or security-like instruments.
     An unrelated third party (expected loss investor) absorbs credit losses, up to a maximum contractual amount, that may occur in the future on the assets in the multi-seller conduits (multi-seller conduit first-loss position) before the multi-seller conduits’ debt holders and us. In return for assuming this multi-seller conduit first-loss position, each multi-seller conduit pays the expected loss investor a return commensurate with its risk position. The expected loss investor absorbs a majority of each multi-seller conduit’s expected losses, when compared to us; therefore, we are not the Primary Beneficiary and do not consolidate these conduits under AcG-15. However, we continue to hold a significant variable interest in these multi-seller conduits resulting from our provision of backstop liquidity facilities, partial credit enhancement and entitlement to residual fees.
     We hold significant variable interests in third-party asset-backed security conduits primarily through providing liquidity support and credit enhancement facilities. However we are not the Primary Beneficiary and do not consolidate these conduits under AcG-15.
     The liquidity and credit enhancement facilities are included and described in our disclosure on guarantees in Note 27.
Investment funds
We enter into derivatives with third parties including mutual funds, unit investment trusts and other investment funds to provide their investors with the desired exposure and hedge our exposure from these derivatives by investing in other funds. We are the Primary Beneficiary when our participation in the derivative or our investment in other funds exposes us to a majority of the respective expected losses.
Structured finance VIEs
We finance VIEs that are part of transactions structured to achieve a desired outcome such as limiting exposure to specific assets or risks, obtaining indirect exposure to financial assets, supporting an enhanced yield, funding specific assets and meeting client requirements. We consolidate structured finance VIEs in which our interests expose us to a majority of the expected losses.
Creation of credit investment products
We use VIEs to generally transform credit derivatives into cash instruments, to distribute credit risk and to create customized credit products to meet investors’ specific requirements. We enter into derivative contracts with these entities in order to convert various risk factors such as yield, currency or credit risk of underlying assets to meet the needs of the investors. We transfer assets to these VIEs as collateral for notes issued but the transfer of assets does not meet sale recognition criteria under AcG-12. In certain instances, we invest in the notes issued by these VIEs, which requires us to consolidate them when we are the Primary Beneficiary.
Compensation vehicles
We use compensation trusts, which primarily hold our own common shares, to economically hedge our obligation to certain employees under some of our stock-based compensation programs. We consolidate the trusts in which we are the Primary Beneficiary.
Capital trusts
RBC Subordinated Notes Trust (Trust III) was created in 2007 to issue $1 billion of innovative subordinated debentures and RBC Capital Trust II (Trust II) was created in 2003 to issue $900 million of innovative capital instruments. We issued senior deposit notes of the same amounts to Trust II, and a senior deposit note of $999.8 million to Trust III. Although we own the common equity and voting control of these trusts, we are not the Primary Beneficiary since we are not exposed to the majority of the expected losses, and we do not have a significant interest in these trusts. For details on our innovative capital instruments, refer to Note 17.
Securitization of our financial assets
We employ SPEs in the process of securitizing our assets, none of which are consolidated under AcG-15. One entity is a QSPE under AcG-12, which is specifically exempt from consolidation under AcG-15, and our level of participation in each of the remaining SPEs relative to others does not expose us to a majority of the expected losses. We also do not have significant interests in these SPEs. For details on our securitization activities, refer to Note 5.
 
NOTE 7 DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES
Derivative financial instruments are financial contracts whose value is derived from an underlying interest rate, foreign exchange rate, equity or commodity instrument or index.
Types of derivatives
Forwards and futures
Forward contracts are effectively tailor-made agreements that are transacted between counterparties in the over-the-counter market, whereas futures are standardized contracts with respect to amounts and settlement dates, and are traded on regular future exchanges. Examples of forwards and futures are described below:
     Interest rate forwards (forward rate agreements) and futures are contractual obligations to buy or sell an interest-rate sensitive financial instrument on a predetermined future date at a specified price.
     Foreign exchange forwards and futures are contractual obligations to exchange one currency for another at a specified price for settlement at a predetermined future date.
Equity forwards and futures are contractual obligations to buy or sell at a fixed value (the contracted price) of an equity index, a basket of stocks or a single stock at a predetermined future date.
Swaps
Swaps are over-the-counter contracts in which two counterparties exchange a series of cash flows based on agreed upon rates to a notional amount. The various swap agreements that we enter into are as follows:
     Interest rate swaps are agreements where two counterparties exchange a series of payments based on different interest rates applied to a notional amount in a single currency. Cross currency swaps involve the exchange of fixed payments in one currency for the receipt of fixed payments in another currency. Cross currency interest rate swaps involve the exchange of both interest and principal amounts in two different currencies.
     Equity swaps are contracts in which one counterparty agrees to pay or receive from the other cash flows based on changes in the value of an equity index, a basket of stocks or a single stock.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements   133

 

 

 
NOTE 7 DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES (CONTINUED)
Options
Options are contractual agreements under which the seller (writer) grants the purchaser the right, but not the obligation, either to buy (call option) or sell (put option), a security, exchange rate, interest rate, or other financial instrument or commodity at a predetermined price, at or by a specified future date. The seller (writer) of an option can also settle the contract by paying the cash settlement value of the purchaser’s right. The seller (writer) receives a premium from the purchaser for this right. The various option agreements that we enter into include interest rate options, foreign currency options and equity options.
Credit derivatives
Credit derivatives are over-the-counter contracts that transfer credit risk related to an underlying financial instrument (referenced asset) from one counterparty to another. Examples of credit derivatives include credit default swaps, credit default baskets and total return swaps.
     Credit default swaps provide protection against the decline in value of the referenced asset as a result of specified credit events such as default or bankruptcy. It is similar in structure to an option whereby the purchaser pays a premium to the seller of the credit default swap in return for payment related to the deterioration in the value of the referenced asset. Credit default baskets are similar to credit default swaps except that the underlying referenced financial instrument is a group of assets instead of a single asset.
     Total return swaps are contracts where one counterparty agrees to pay or receive from the other cash flows based on changes in the value of the referenced asset.
Other derivative products
We also transact in other derivative products including precious metal and commodity derivative contracts in both the over-the-counter and exchange markets. Certain warrants and loan commitments that meet the definition of derivative are also included as derivative instruments.
Derivatives issued for trading purposes
Most of our derivative transactions relate to sales and trading activities. Sales activities include the structuring and marketing of derivative products to clients to enable them to transfer, modify or reduce current or expected risks. Trading involves market-making, positioning and arbitrage activities. Market-making involves quoting bid and offer prices to other market participants with the intention of generating revenue based on spread and volume. Positioning involves managing market risk positions with the expectation of profiting from favourable movements in prices, rates or indices. Arbitrage activities involve identifying and profiting from price differentials between markets and products.
Derivatives issued for other than trading purposes
We also use derivatives for purposes other than trading, primarily for hedging, in conjunction with the management of interest rate, credit and foreign exchange risk related to our own asset/liability management, funding and investment activities.
     Interest rate swaps are used to adjust exposure to interest rate risk by modifying the repricing or maturity characteristics of existing and/or anticipated assets and liabilities, including funding and investment activities. Purchased interest rate options are used to hedge redeemable deposits and other options embedded in consumer products. We manage our exposure to foreign currency risk with cross currency swaps and foreign exchange forward contracts. We use credit derivatives to manage our credit exposures and for risk diversification in our lending portfolio.
     Certain derivatives and cash instruments are specifically designated and qualify for hedge accounting. We apply hedge accounting to minimize significant unplanned fluctuations in earnings caused by changes in interest rates or foreign exchange rates. Interest rate and currency fluctuations will either cause assets and liabilities to appreciate or depreciate in market value or cause variability in anticipated cash flows. When a hedging instrument functions effectively, gains, losses, revenue and expenses of the hedging instrument will offset the gains, losses, revenue and expenses of the hedged item. When derivatives are designated as the hedging instrument, all components of each derivative’s change in fair value are included in the assessment and measurement of hedge effectiveness. When cash instruments are designated for hedges of currency risks, only changes in their value due to currency risk are included in the assessment and measurement of hedge effectiveness.
     We did not apply hedge accounting to any anticipated transactions or firm commitments during the year. As at October 31, 2007, after-tax net unrealized gains of $24 million were recognized in AOCI, representing the cumulative effective portions of our cash flow hedges. The net amount of gains and losses reported in AOCI that is expected to be reclassified to Net interest income within the next 12 months is not estimated to be material.
     From time to time, we also enter into derivative transactions to economically hedge certain business strategies that do not otherwise qualify for hedge accounting, or where hedge accounting is not considered economically feasible to implement. In such circumstances, changes in fair value are reflected in Non-interest income.
Hedge activities
                         
 
    2007  
                    After-tax  
    Net gains (losses)     Net gains (losses)     unrealized  
    included in     included in     gains (losses)  
    Non-interest income     Net interest income     included in OCI  
 
Fair value hedges
                        
Ineffective portion
   $ (14 )   $ n.a.     $ n.a.  
Cash flow hedges
                        
Ineffective portion
     (9 )     n.a.       n.a.  
Effective portion
     n.a.       n.a.       80  
Reclassified to income during the year (1)
     n.a.       (47 )     n.a.  
Net investment hedges
                        
Foreign currency losses
     n.a.       n.a.       (2,965 )
Gains from hedges
     n.a.       n.a.       1,804  
 
(1)   An after-tax equivalent amount of $31 million was reclassified from AOCI.
 
n.a.   not applicable
Royal Bank of Canada: Annual Report 2007
134   Consolidated Financial Statements

 

 

Notional amount of derivatives by term to maturity
                                                                 
 
    Term to maturity     2007     2006  
    Within     1 to     Over 5                     Other than             Other than  
    1 year     5 years     years (1)     Total     Trading     trading     Trading     trading  
 
Over-the-counter contracts
                                                                
Interest rate contracts
                                                                
Forward rate agreements
   $ 197,733     $ 4,120     $ —     $ 201,853     $ 201,853     $ —     $ 315,378     $ —  
Swaps
     896,816       907,875       449,855       2,254,546       2,096,153       158,393       1,874,206       140,232  
Options purchased
     22,986       35,405       32,197       90,588       89,585       1,003       99,172       86  
Options written
     38,403       39,854       71,485       149,742       149,169       573       73,566       —  
Foreign exchange contracts
Forward contracts
     706,342       21,149       14,285       741,776       710,961       30,815       626,484       33,033  
Cross currency swaps
     2,648       7,978       7,521       18,147       17,748       399       18,553       1,072  
Cross currency interest rate swaps
     53,818       141,584       82,936       278,338       242,319       36,019       228,090       20,707  
Options purchased
     28,961       7,472       330       36,763       36,756       7       65,572       71  
Options written
     30,500       7,559       296       38,355       38,355       —       68,337       51  
Credit derivatives (2)
     18,548       183,650       197,026       399,224       393,247       5,977       219,054       2,722  
Other contracts (3)
     22,614       20,129       31,203       73,946       73,804       142       86,548       573  
Exchange-traded contracts
Interest rate contracts
                                                                
Futures—long positions
     68,553       8,806       5       77,364       77,086       278       146,886       524  
Futures—short positions
     112,912       19,278       2       132,192       132,008       184       211,131       901  
Options purchased
     14,945       19       —       14,964       14,964       —       71,926       —  
Options written
     4,656       —       —       4,656       4,656       —       119,194       —  
Foreign exchange contracts
Futures—long positions
     100       227       —       327       327       —       6,070       —  
Futures—short positions
     9,521       168       —       9,689       9,689       —       26,088       —  
Other contracts (3)
     252,784       1,396       26       254,206       254,206       —       257,154       —  
 
 
   $ 2,482,840     $ 1,406,669     $ 887,167     $ 4,776,676     $ 4,542,886     $ 233,790     $ 4,513,409     $ 199,972  
 
(1)   Includes contracts maturing in over 10 years with a notional value of $205,976 million (2006 —$135,951 million). The related gross positive replacement cost is $10,910 million (2006—$3,857 million).
 
(2)   Comprises credit default swaps, total return swaps and credit default baskets, including credit derivatives given guarantee treatment for the OSFI regulatory reporting purposes. Credit derivatives with a notional value of $5,530 million (2006—$2,116 million) are economic hedges.
 
(3)   Comprises precious metal, commodity and equity-linked derivative contracts other than embedded equity-linked contracts.
The following table provides the fair value of our derivative financial instruments:
Fair value of derivative instruments
                                                                 
 
    2007     2006  
 
    Average fair value     Year-end     Average fair value     Year-end  
    for year ended (1)     fair value     for year ended (1)     fair value  
    Positive     Negative     Positive     Negative     Positive     Negative     Positive     Negative  
 
Held or issued for trading purposes
Interest rate contracts
                                                                
Forward rate agreements
   $ 44     $ 49     $ 72     $ 25     $ 52     $ 50     $ 44     $ 60  
Swaps
     13,938       14,241       14,250       14,446       12,150       12,003       12,258       11,969  
Options purchased
     621       —       488       —       795       —       602       —  
Options written
     —       786       —       625       —       888       —       698  
 
 
     14,603       15,076       14,810       15,096       12,997       12,941       12,904       12,727  
 
Foreign exchange contracts
Forward contracts
     8,342       8,508       14,503       14,410       6,740       6,969       5,493       5,758  
Cross currency swaps
     2,231       1,522       3,066       2,141       2,041       1,522       2,151       1,522  
Cross currency interest rate swaps
     8,987       9,419       13,634       14,250       7,010       8,275       6,703       8,319  
Options purchased
     1,044       —       1,221       —       1,571       —       1,055       —  
Options written
     —       1,028       —       1,302       —       1,582       —       994  
 
 
     20,604       20,477       32,424       32,103       17,362       18,348       15,402       16,593  
 
Credit derivatives (2)
     3,964       3,508       10,416       9,375       1,139       975       1,795       1,580  
Other contracts (3)
     6,096       9,537       4,925       10,317       5,623       8,803       5,798       9,221  
 
 
   $ 45,267     $ 48,598     $ 62,575     $ 66,891     $ 37,121     $ 41,067     $ 35,899     $ 40,121  
 
Held or issued for other than trading purposes
Interest rate contracts
                                                                
Swaps
                   $ 1,110     $ 760                     $ 1,100     $ 940  
Options purchased
                     6       —                       —       —  
Options written
                     —       25                       —       —  
 
 
                     1,116       785                       1,100       940  
 
Foreign exchange contracts
Forward contracts
                     921       503                       102       236  
Cross currency swaps
     2       9                       5       5  
Cross currency interest rate swaps
     1,371       3,635                       607       631  
Options purchased
                     —       —                       1       —  
Options written
                     —       —                       —       1  
 
 
                     2,294       4,147                       715       873  
 
Credit derivatives (2)
                     36       30                       20       30  
Other contracts (3)
                     20       42                       85       281  
 
 
                     3,466       5,004                       1,920       2,124  
 
Total gross fair values before netting (4)
     66,041       71,895                       37,819       42,245  
Impact of master netting agreements
With intent to settle net or simultaneously (5)
     (473 )     (473 )                     (137 )     (137 )
Without intent to settle net or simultaneously (6)
   (38,256 )     (38,256 )                     (18,952 )     (18,952 )
 
Total
                   $ 27,312     $ 33,166                     $ 18,730     $ 23,156  
 
(1)   Average fair value amounts are calculated based on monthly balances.
 
(2)   Comprises credit default swaps, total return swaps and credit default baskets, including credit derivatives given guarantee treatment for the OSFI regulatory reporting purposes.
 
(3)   Comprises precious metal, commodity and equity-linked derivative contracts. Certain warrants and loan commitments that meet the definition of derivatives are also included.
 
(4)   The positive year-end fair value excludes margin requirements of $1,017 million (2006—$721 million) and the negative year-end fair value excludes market and credit valuation adjustments of $588 million (2006—$366 million).
 
(5)   Impact of offsetting credit exposures on contracts where we have both a legally enforceable master netting agreement in place and we intend to settle the contracts on either a net basis or simultaneously.
 
(6)   Additional impact of offsetting credit exposures on contracts where we have a legally enforceable master netting agreement in place but do not intend to settle the contracts on a net basis or simultaneously.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  135

 

 

 
NOTE 7 DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES (continued)
Derivative-related credit risk
Credit risk from derivative transactions is generated by the potential for the counterparty to default on its contractual obligations when one or more transactions have a positive market value to us. Therefore, derivative-related credit risk is represented by the positive fair value of the instrument and is normally a small fraction of the contract’s notional amount.
     We subject our derivative-related credit risk to the same credit approval, limit and monitoring standards that we use for managing other transactions that create credit exposure. This includes evaluating the creditworthiness of counterparties, and managing the size, diversification and maturity structure of the portfolio. Credit utilization for all products is compared with established limits on a continual basis and is subject to a standard exception reporting process. We utilize a single internal rating system for all credit risk exposure. In most cases, these internal ratings approximate the external risk ratings of public rating agencies.
     Netting is a technique that can reduce credit exposure from derivatives and is generally facilitated through the use of master netting agreements. The master netting agreement provides for a single net settlement of all financial instruments covered by the agreement in the event of default. However, credit risk is reduced only to the extent that our financial obligations to the same counterparty can be set off against obligations of the counterparty to us. The two main categories of netting are close-out netting and settlement netting. Under the close-out netting provision, if the counterparty defaults, we have the right to terminate all transactions covered by the master netting agreement at the then-prevailing market values and to sum the resulting market values, offsetting negative against positive values, to arrive at a single net amount owed by either the counterparty or us. Under the settlement netting provision, all payments and receipts in the same currency and due on the same day between specified branches are netted, generating a single payment in each currency, due either by us or the counterparty. We maximize the use of master netting agreements to reduce derivative-related credit exposure. Our overall exposure to credit risk that is reduced through master netting agreements may change substantially following the reporting date as the exposure is affected by each transaction subject to the agreement as well as by changes in underlying market rates. Measurement of our credit exposure arising out of derivative transactions is reduced to reflect the effects of netting in cases where the enforceability of that netting is supported by appropriate legal analysis as documented in our trading credit risk policies.
     The use of collateral is another significant credit mitigation technique for managing derivative-related counterparty credit risk. Marked-to-market provisions in our agreements with some counterparties, typically in the form of a Credit Support Annex, provide RBC with the right to request that the counterparty pay down or collateralize the current market value of its derivatives positions when the value passes a specified threshold amount.
      During 2007, 2006 and 2005, neither our actual credit losses arising from derivative transactions nor the level of impaired derivative contracts were significant. The tables below show replacement cost, credit equivalent and risk-adjusted amounts of our derivatives both before and after the impact of netting.
     Replacement cost represents the total fair value of all outstanding contracts in a gain position, before factoring in the master netting agreements. The amounts in the table below exclude fair value of $955 million (2006—$734 million) relating to exchange-traded instruments as they are subject to daily margining and are deemed to have no credit risk.
     The credit equivalent amount is defined as the sum of the replacement cost plus an add-on amount for potential future credit exposure as defined by the OSFI.
     The risk-adjusted amount is determined by applying the standard OSFI-defined measures of counterparty risk to the credit equivalent amount.
Derivative-related credit risk
                                                 
 
    2007     2006  
    Replacement     Credit equivalent     Risk-adjusted     Replacement     Credit equivalent     Risk-adjusted  
    cost     amount     balance     cost     amount     balance  
Interest rate contracts
                                                
Forward rate agreements
   $ 72     $ 92     $ 22     $ 44     $ 109     $ 22  
Swaps
     15,360       23,484       5,213       13,358       21,031       4,452  
Options purchased
     364       1,032       248       591       1,164       260  
 
 
     15,796       24,608       5,483       13,993       22,304       4,734  
 
Foreign exchange contracts
                                                
Forward contracts
     15,424       22,222       5,674       5,595       12,413       3,310  
Swaps
     18,073       32,901       6,138       9,466       22,697       4,305  
Options purchased
     1,221       1,832       466       1,056       2,244       502  
 
 
     34,718       56,955       12,278       16,117       37,354       8,117  
 
Credit derivatives (1)
     10,416       35,026       8,465       1,795       6,975       2,009  
Other contracts (2)
     4,120       6,723       2,251       5,160       8,696       2,760  
 
Derivatives before master netting agreements
   $ 65,050     $ 123,312     $ 28,477     $ 37,065     $ 75,329     $ 17,620  
Impact of master netting agreements
     (38,729 )     (65,339 )     (14,020 )     (19,089 )     (31,831 )     (7,188 )
 
Total derivatives after master netting agreement (3)
   $ 26,321     $ 57,973     $ 14,457     $ 17,976     $ 43,498     $  10,432   
 
(1)   Comprises credit default swaps, total return swaps and credit default baskets. The above excludes credit derivatives issued for other than trading purposes related to bought and sold protection with a replacement cost of $36 million (2006 — $20 million). Credit derivatives issued for other than trading purposes related to sold protection with a replacement cost of $.4 million (2006 — $20 million) had a credit equivalent amount of $447 million (2006 — $283 million) and risk-adjusted asset amount of $447 million (2006 — $283 million) which were given guarantee treatment per the OSFI guidance.
 
(2)   Comprises precious metal, commodity and equity-linked derivative contracts.
 
(3)   The total credit equivalent amount after netting includes collateral applied of $2,228 million (2006 — $1,310 million).
Royal Bank of Canada: Annual Report 2007
136  Consolidated Financial Statements

 

 

Replacement cost of derivative financial instruments by risk rating and by counterparty type
                                                                         
 
    Risk rating (1)     Counterparty type (2)  
As at October 31,2007   AAA, AA     A     BBB     BB or
lower		     Total     Banks     OECD
governments		     Other     Total  
 
Gross positive replacement cost
   $ 42,142     $ 14,731     $ 6,149     $ 2,064     $ 65,086     $ 38,250     $ 8,188     $ 18,648     $ 65,086  
Impact of master netting agreements
     (28,042 )     (8,047 )     (2,367 )     (273 )     (38,729 )     (31,193 )     —       (7,536 )     (38,729 )
 
Replacement cost (after netting agreements) (3)
   $ 14,100     $ 6,684     $ 3,782     $ 1,791     $ 26,357     $ 7,057     $ 8,188     $ 11,112     $ 26,357  
 
Replacement cost (after netting agreements)—2006 (3)
   $ 8,573     $ 5,393     $ 2,270     $ 1,760     $ 17,996     $ 5,678     $ 5,891     $ 6,427     $ 17,996  
 
(1)   Our internal risk ratings for major counterparty types approximate those of public rating agencies. Ratings of AAA, AA, A and BBB represent investment grade ratings and ratings of BB or lower represent non-investment grade ratings.
 
(2)   Counterparty type is defined in accordance with the capital adequacy requirements of the OSFI.
 
(3)   Includes credit derivatives issued for other than trading purposes with a total replacement cost of $36 million (2006 — $20 million).
 
NOTE 8 PREMISES AND EQUIPMENT
                                                 
 
    2007     2006
            Accumulated     Net book             Accumulated     Net book  
    Cost     depreciation     value     Cost     depreciation     value  
 
Land
   $ 133     $ —     $ 133     $ 134     $ —     $ 134  
Buildings
     553       333       220       511       321       190  
Computer equipment
     3,049       1,986       1,063       2,462       1,698       764  
Furniture, fixtures and other equipment
     1,059       764       295       1,012       736       276  
Leasehold improvements
     1,147       727       420       1,127       673       454  
 
 
   $ 5,941     $ 3,810     $ 2,131     $ 5,246     $ 3,428     $ 1,818  
 
The depreciation expense for premises and equipment for 2007 was $434 million (2006 — $405 million; 2005 — $414 million).
 
NOTE 9 RBC DEXIA INVESTOR SERVICES JOINT VENTURE
RBC Dexia Investor Services
We operate our institutional and investor services business (IIS) through our joint venture, RBC Dexia Investor Services (RBC Dexia IS). During the year, RBC Dexia IS finalized the net assets contribution requirement outlined in the joint venture agreement. As a result, it was determined that we had contributed €27 million ($41 million) of net assets in excess of the amount required. This excess was settled by RBC Dexia IS in cash and recognized by us as a reduction in our investment in the joint venture.
     Assets and liabilities representing our interest in RBC Dexia IS and our proportionate share of its financial results before adjusting for related party transactions are presented in the following tables:
                 
 
    As at  
    October 31, 2007     October 31, 2006  
Consolidated Balance Sheets
                
Assets (1)
   $ 15,544     $ 12,354  
Liabilities
     14,533       11,396  
(1)   Includes $69 million (2006-$69 million) of goodwill and $179 million (2006-$208 million) of intangible assets.
                 
 
    For the     For the nine  
    year ended     months ended  
    October 31, 2007     October 31, 2006 (1)  
 
Consolidated Statements of Income
                
Net interest income
   $ 116     $ 75  
Non-interest income
     600       363  
Non-interest expense
     529       315  
Net income
     125       73  
 
                
Consolidated Statements of Cash Flows
                
Cash flows from (used in) operating activities
   $ (546 )   $ (71 )
Cash flows from (used in) investing activities
     (2,299 )     (97 )
Cash flows from (used in) financing activities
     2,856       165  
 
(1)   For the year ended October 31, 2006, we did not report our proportionate share of RBC Dexia IS results for our quarter ended January 31, 2006 as the joint venture was formed on January 2, 2006, and we report its results on a one-month lag basis.
We provide certain services to RBC Dexia IS, which include administrative and technology support, human resources, and credit and banking facilities to support its operations. RBC Dexia IS also provides certain services to us, including custody and trusteeship, fund and investment administration, transfer agency and investor services. These services and facilities are provided by the respective parties in the normal course of operations on terms similar to those offered to non-related parties. The amount of income earned and expenses incurred by RBC Dexia IS related to transactions with RBC are as follows:
                 
 
    For the     For the nine  
    year ended     months ended  
    October 31,     October 31,  
    2007     2006(1)  
 
Net interest income
   $ 157     $ 99  
Non-interest income
     26       16  
Non-interest expense
     34       28  
 
(1)   For the year ended October 31, 2006, we did not report the amounts of income earned and expenses incurred by RBC Dexia IS related to transactions with RBC for our quarter ended January 31, 2006 as the joint venture was formed on January 2, 2006, and we report its results on a one-month lag basis.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  137

 

 

NOTE 10 GOODWILL AND OTHER INTANGIBLES
Effective February 7, 2007, as discussed in Note 30, our previous three business segments were reorganized into four business segments. This reorganization resulted in the realignment of certain reporting units. Accordingly, we have reallocated our goodwill to the new reporting units using the relative fair value approach. The following table discloses the changes in goodwill during 2006 and 2007, including the reallocation of goodwill to the new reporting units:
Goodwill
                                 
 
            RBC              
    RBC     U.S. and              
    Canadian     International     RBC        
    Personal and     Personal and     Capital        
    Business     Business     Markets     Total  
 
Balance at October 31, 2005
   $ 2,419     $ 831     $ 953     $ 4,203  
Goodwill acquired during the year
     —       86       —       86  
Other adjustments (1), (2)
     72       (17 )     (40 )     15  
 
Balance at October 31, 2006
   $ 2,491     $ 900     $ 913     $ 4,304  
 
Goodwill acquired between November 1, 2006 and January 31, 2007
     —       406       121       527  
Other adjustments (3)
     9       58       34       101  
 
Balance at January 31, 2007
   $ 2,500     $ 1,364     $ 1,068     $ 4,932  
 
(1)   Other adjustments in 2006 primarily include the impact of foreign exchange translations on foreign currency-denominated goodwill, changes in goodwill related to our IIS business with RBC Dexia IS (refer to Note 9), and the transfer of $6 million of housing tax credit syndication business goodwill from RBC U.S. and International Personal and Business to RBC Capital Markets. Refer to Note 30.
 
(2)   During 2006, we adjusted the foreign exchange translation of certain foreign currency-denominated goodwill of RBC Canadian Personal and Business to better align with the nature of the net assets supporting the segment. This resulted in an increase of $182 million of goodwill for RBC Canadian Personal and Business. A corresponding increase was made to Unrealized foreign currency translation adjustments on our Consolidated Statements of Changes in Shareholders’ Equity.
 
(3)   Other adjustments in the first quarter of 2007 primarily include the impact of foreign exchange translations on foreign currency-denominated goodwill.
As a result of the application of the relative fair value approach for the business reorganization, goodwill as at January 31, 2007 has been reallocated as follows:
Reallocation of goodwill
                                                 
 
    Goodwill                                     Goodwill  
    balance before                     U.S. &             balance after  
    business     Canadian     Wealth     International     Capital     business  
    reorganization     Banking     Management     Banking     Markets     reorganization  
 
RBC Canadian Personal and Business
   $ 2,500     $ 2,069     $ 431      $ —     $ —     $ 2,500  
RBC U.S. and International Personal and Business
     1,364       —       583       781       —       1,364  
RBC Capital Markets
     1,068       —       —       109       959       1,068  
 
Balance at January 31, 2007
   $ 4,932     $ 2,069     $ 1,014     $ 890     $ 959     $ 4,932  
 
Goodwill acquired between February 1 and October 31, 2007
     372       —       31       323       18       372  
Other adjustments (1)
     (552 )     (19 )     (163 )     (217 )     (153 )     (552 )
 
Balance at October 31, 2007
   $ 4,752     $ 2,050     $ 882     $ 996     $ 824     $ 4,752  
 
(1)   Other adjustments in the last three quarters of 2007 primarily include the impact of foreign exchange translations on foreign currency-denominated goodwill.
We have also completed the annual assessment for goodwill impairment in all reporting units and have determined that there was no goodwill impairment for the year ended October 31, 2007 (2006 — nil; 2005 — nil).
Other intangibles
                                                 
 
    2007     2006  
    Gross carrying     Accumulated     Net carrying     Gross carrying     Accumulated     Net carrying  
    amount     amortization (1)     amount     amount     amortization (1)     amount  
 
Core deposit intangibles
   $ 376     $ (170 )   $ 206     $ 324     $ (163 )   $ 161  
Customer lists and relationships
     605       (200 )     405       625       (156 )     469  
Mortgage servicing rights
     47       (30 )     17       44       (32 )     12  
 
 
   $ 1,028     $ (400 )   $ 628     $ 993     $ (351 )   $ 642  
 
(1)   Total amortization expense for 2007 was $96 million (2006 — $76 million; 2005 — $50 million).
The projected amortization of Other intangibles for each of the years ending October 31, 2008 to October 31, 2012 is approximately $86 million. There were no writedowns of intangible assets due to impairment for the year ended October 31, 2007 (2006 — nil; 2005 — nil).
Royal Bank of Canada: Annual Report 2007
138  Consolidated Financial Statements

 

 

NOTE 11 SIGNIFICANT ACQUISITIONS AND DISPOSITIONS
2007
In December 2006, we completed the acquisition of Atlanta, Georgia-based Flag Financial Corporation (Flag) and its subsidiary, Flag Bank, and in March 2007, we completed the acquisition of 39 branches of AmSouth Bank in Alabama (AmSouth branches). Details of these acquisitions are as follows:
                 
 
    Flag     AmSouth branches (1)  
 
Acquisition date
   December 8, 2006     March 9, 2007  
 
Business segment
   U.S. & International Banking     U.S. & International Banking  
 
Percentage of shares acquired
     100 %     n.a.  
 
Purchase consideration in the currency of the transaction
   Cash payment of US$435     Cash payment of US$343  
 
Purchase consideration in Canadian dollar equivalent
   $ 498     $ 405  
 
Fair value of tangible assets acquired
   $ 1,912     $ 2,368  
Fair value of liabilities assumed
     (1,870 )     (2,369 )
 
Fair value of identifiable net assets acquired (net liabilities assumed)
     42       (1 )
Core deposit intangibles and other intangibles (2), (3)
     50       83  
Goodwill
     406       323  
 
Total purchase consideration
   $ 498     $ 405  
 
(1)   The purchase price allocation for the AmSouth branches is preliminary; it will be finalized once the valuations of certain assets and liabilities are completed.
 
(2)   Core deposit intangibles are amortized on a straight-line basis over an estimated average useful life of seven years.
 
(3)   Included in the acquisition of Flag was $7 million of Other intangibles ($nil for AmSouth branches) which relates to non-compete agreements and are amortized over the term of the agreements for a maximum of three years.
 
n.a.   not applicable
Other acquisitions
Capital Markets
During 2007, we completed three acquisitions for a total cost of US$150 million (C$170 million), which were paid in cash: (i) Ohio-based Seasongood & Mayer, LLC, a public finance firm and leading underwriter of municipal debt, and its wholly owned subsidiary, Seasongood Asset Management, an investment advisor to public funds clients, (ii) the broker-dealer business and certain other assets of the Carlin Financial Group, a New York-based broker-dealer, and (iii) Colorado-based Daniels & Associates, L.P., an M&A advisory firm specializing in the communications, media and entertainment, and technology sectors. These acquisitions are not material to Capital Markets and resulted in goodwill of $160 million.
Wealth Management
On May 18, 2007, we completed the acquisition of New Jersey-based J.B. Hanauer & Co., a privately held financial services firm which specializes in retail fixed income and wealth management services, for US$42 million (C$45 million) in cash. The acquisition is not material to Wealth Management and resulted in goodwill of $18 million.
Pending acquisitions
U.S. & International Banking
On April 17, 2007, we announced our intention to acquire a 50% interest in Fidelity Merchant Bank & Trust Limited, the Bahamas-based wholly owned subsidiary of Fidelity Bank & Trust International Limited to form a joint venture to be called Royal Fidelity Merchant Bank & Trust Limited which will provide certain corporate finance and advisory, investment management, stock brokerage, share registrar and transfer agency, pension and mutual fund administration services. This transaction is expected to close in the first quarter of 2008.
     On September 6, 2007, RBC Centura Banks, Inc. announced the signing of a definitive merger agreement pursuant to which RBC Centura Banks, Inc. agreed to acquire Birmingham-based Alabama National BanCorporation (ANB), parent of 10 subsidiary banks and other affiliated businesses in Alabama, Florida and Georgia. Under the agreement, shareholders of ANB will receive US$80 per share payable in cash, RBC common shares or a combination of each, valuing the deal at approximately US$1.6 billion (C$1.5 billion as at October 31, 2007), with the total transaction consideration consisting of one-half cash and one-half RBC common shares. The acquisition is subject to customary closing conditions, including approval by U.S. and Canadian regulators and by ANB shareholders. The transaction is expected to close in early calendar year 2008.
     On October 2, 2007, we and the RBTT Financial Group (RBTT) announced an agreement to combine our Caribbean retail banking operations with RBTT’s through the acquisition of RBTT for a total purchase price of TT$13.8 billion (C$2 billion as at October 31, 2007). RBTT is a Caribbean-owned banking and financial services group which offers a complete range of banking and financial intermediate services to customers in Trinidad and Tobago and the Caribbean. Under the agreement, RBTT shareholders will receive per share consideration of TT$40 payable 60% in cash and 40% in RBC common shares. The number of RBC common shares to be received by RBTT shareholders is subject to a plus/minus 10% “collar” based on our share price of US$54.42. The acquisition is subject to customary closing conditions, including approval by the Trinidad and Tobago and Canadian and other regulators and RBTT shareholders. This transaction is expected to close by the middle of calendar year 2008.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  139

 

 

 NOTE 11 SIGNIFICANT ACQUISITIONS AND DISPOSITIONS (continued)
2006
Acquisitions
Wealth Management
In November 2005, we completed the acquisition of operations of Abacus Financial Services Group Limited (Abacus) in London, Jersey, Guernsey, Edinburgh and Cheltenham. Abacus is based in Jersey, Channel Islands, and provides wealth management and fiduciary services to private and corporate clients primarily in the British Isles and Continental Europe.
     In October 2006, we completed the acquisition of American Guaranty & Trust (AG&T) which is based in Wilmington, Delaware, and offers complete personal trust and custody services through a unique strategic partnership with professional advisors.
     The details of these acquisitions are as follows:
                 
   
    Abacus     AG&T
   
Acquisition date
   November 30, 2005     October 3, 2006  
   
Business segment
   Wealth Management (1)     Wealth Management (1)  
   
Percentage of shares acquired
     100%       100%
   
Purchase consideration in the currency of the transaction
   Cash payment of £$105 (2)     Cash payment of US$12.5  
   
Purchase consideration in Canadian dollar equivalent
   $ 213     $ 14  
   
Fair value of tangible assets acquired
   $ 43     $ 3  
Fair value of liabilities assumed
     (23)       —  
   
Fair value of identifiable net tangible assets acquired
     20       3  
Customer lists and relationships (3)
     116       2  
Goodwill
     77       9  
   
Total purchase consideration
   $ 213     $ 14  
 
(1)   These acquisitions, which were previously included in the operations of RBC U.S. and International Personal and Business segment, are included in the Wealth Management business segment effective February 2, 2007 upon reorganization of our business segments. Refer to Note 30.
 
(2)   Includes £20 million placed in an escrow account for future payments of claims as agreed to in the purchase agreement. Amounts remaining in the escrow account will be released to the vendors over a three-year period after completion of the acquisition.
 
(3)   Customer lists and relationships are amortized on a straight-line basis over an estimated average useful life of 15 years.
Dispositions
On September 2,2005, we completed the sale of RBC Mortgage Company (RBC Mortgage) to New Century Mortgage Corporation and Home123 Corporation (Home123), pursuant to which Home123 acquired certain assets of RBC Mortgage including its branches, and hired substantially all of its employees. RBC Mortgage disposed of substantially all of its remaining assets and obligations by the end of 2006 and the residual balances of RBC Mortgage in 2007 are immaterial. These residual balances are no longer recorded separately in our Consolidated Financial Statements for 2007 and changes in the amounts are now reported in Corporate Support. Prior to 2007, the results of RBC Mortgage are presented separately as discontinued operations.
 NOTE 12 OTHER ASSETS
                 
 
    2007     2006  
 
Receivable from brokers, dealers and clients
   $ 4,048     $ 3,172  
Accrued interest receivable
     2,608       2,229  
Investment in associated corporations and limited partnerships
     1,420       1,614  
Insurance-related assets (1)
     827       702  
Net future income tax asset (refer to Note 24)
     1,251       1,104  
Prepaid pension benefit cost (2) (refer to Note 20)
     590       761  
Cheques and other items in transit
     —       489  
Other
     7,109       5,346  
 
 
   $ 17,853     $ 15,417  
 
(1)   Insurance-related assets include policy loan balances, premiums outstanding, amounts due from other insurers in respect of reinsurance contracts and pooling arrangements, and deferred acquisition costs.
 
(2)   Prepaid pension benefit cost represents the cumulative excess of pension fund contributions over pension benefit expense.
Royal Bank of Canada: Annual Report 2007
140  Consolidated Financial Statements

 

 

 
NOTE 13 DEPOSITS
The following table details our deposit liabilities:
                                         
 
    2007     2006  
    Demand (1)     Notice (2)     Term (3)     Total     Total  
 
Personal
   $ 14,022     $ 36,537     $ 65,998     $ 116,557     $ 114,040  
Business and government (4), (5)
     64,934       16,930       138,022       219,886       189,140  
Bank
     4,135       221       24,406       28,762       40,343  
 
 
   $ 83,091     $ 53,688     $ 228,426     $ 365,205     $ 343,523  
 
Non-interest-bearing
                                        
Canada
                           $ 28,254     $ 19,088  
United States
                             2,285       2,293  
Other International
                             1,693       1,241  
Interest-bearing
                                        
Canada (4), (5)
                             155,190       174,170  
United States
                             41,514       50,123  
Other International
                             136,269       96,608  
 
 
                           $ 365,205     $ 343,523  
 
(1)   Deposits payable on demand include all deposits for which we do not have the right to notice of withdrawal. These deposits are primarily chequing accounts.
 
(2)   Deposits payable after notice include all deposits for which we can legally require notice of withdrawal. These deposits are primarily savings accounts.
 
(3)   Term deposits include deposits payable on a fixed date. These deposits include term deposits, guaranteed investment certificates and similar instruments. At October 31, 2007, the balance of term deposits also includes senior deposit notes we have issued to provide long-term funding of $51.5 billion (2006-$33.4 billion).
 
(4)   The senior deposit note of $900 million issued to Trust II (refer to Note 17) is included in Business and government deposits. This senior deposit note bears interest at an annual rate of 5.812% and will mature on December 31, 2053. The note is redeemable at our option, in whole or in part, on and after December 31, 2008, subject to the approval of the OSFI. It may be redeemed earlier, at our option in certain specified circumstances, subject to the approval of the OSFI. Each $1,000 of the note principal is convertible at any time into 40 of our Non-cumulative redeemable First Preferred Shares Series U at the option of Trust II. Trust II will exercise this conversion right in circumstances in which holders of RBC Trust Capital Securities Series 2013 (RBC TruCS 2013) exercise their holder exchange right. Refer to Note 17 for more information on RBC TruCS 2013.
 
(5)   Business and government deposits also include a senior deposit note of $999.8 million issued to RBC Subordinated Notes Trust (Trust III) (refer to Note 17). This senior deposit note bears interest at an annual rate of 4.72% and will mature on April 30, 2017. Subject to the OSFI’s approval, the note is redeemable at our option, in whole or in part, on or after April 30, 2012, at the Redemption Price and may also be redeemed earlier at our option at the Early Redemption Price. The Redemption Price is an amount equal to $1,000 plus the unpaid distributions to the redemption date. The Early Redemption Price is an amount equal to the greater of (i) the Redemption Price, and (ii) the price calculated to provide an annual yield, equal to the yield on Government of Canada bonds from the redemption date to April 30, 2012, plus 11 basis points.
The contractual maturities of the term deposits are as follows:
Term deposits (1)
         
 
    2007  
 
Within 1 year
   $ 171,929  
1 to 2 years
     17,484  
2 to 3 years
     15,290  
3 to 4 years
     9,501  
4 to 5 years
     8,552  
Over 5 years
     5,670  
 
Total
   $ 228,426  
 
(1)   The aggregate amount of term deposits in denominations of $100,000 or more as at October 31, 2007 was $186 billion.
The following table presents the average deposit balances and average rates of interest paid during 2007 and 2006:
Average deposit balances and rates
                                 
 
    Average balances     Average rates  
    2007     2006     2007     2006  
 
Canada
   $ 190,754     $ 183,085       2.97 %     2.74 %
United States
     54,812       48,272       4.68       4.18  
Other International
     122,910       91,942       4.50       3.99  
 
 
   $ 368,476     $ 323,299       3.74 %     3.31 %
 
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements   141

 

 

 
NOTE 14 INSURANCE
Insurance claims and policy benefit liabilities
                 
 
    2007     2006  
 
Life and health
   $ 6,664     $ 6,655  
Property and casualty
     417       386  
Reinsurance
     202       296  
 
Total
   $ 7,283     $ 7,337  
 
Future policy benefit liabilities
   $ 6,610     $ 6,605  
Claims liabilities
     673       732  
 
Total
   $ 7,283     $ 7,337  
 
The net decrease in Insurance claims and policy benefit liabilities over the prior year comprised: (i) the favourable impact of the stronger Canadian dollar on U.S. dollar-denominated liabilities, (ii) a net decrease in reinsurance liabilities reflecting claim payments related to hurricanes Katrina, Rita and Wilma, and (iii) the net increase in life and health and property and casualty liabilities attributable to business growth and market movements on assets backing life and health liabilities.
     Furthermore, the review of various actuarial assumptions and completion of certain actuarial experience studies resulted in a net decrease of $57 million life and $32 million health insurance liabilities. This was predominantly driven by the impact of ongoing experience studies, refinements to cash flow models and methods, investment portfolio changes and updated interest rate assumptions, and includes a cumulative valuation adjustment of $92 million relating to prior periods.
     The changes in the insurance claims and policy benefit liabilities are included in the Insurance policyholder benefits, claims and acquisition expense in our Consolidated Statement of Income in the period in which the estimates changed.
Reinsurance
In the ordinary course of business, our insurance operations reinsure risks to other insurance and reinsurance companies in order to provide greater diversification, limit loss exposure to large risks, and provide additional capacity for future growth. These ceding reinsurance arrangements do not relieve our insurance subsidiaries from their direct obligation to the insureds. We evaluate the financial condition of the reinsurers and monitor our concentrations of credit risks to minimize our exposure to losses from reinsurer insolvency.
     Reinsurance recoverables related to property and casualty insurance business, which are included in Other assets, include amounts related to paid benefits and unpaid claims. Reinsurance recoverables related to life insurance business are included in Insurance claims and policy benefit liabilities to offset the related liabilities.
     Reinsurance amounts (ceded premiums) included in Non-interest income for the years ended October 31 are shown in the table below:
Net premiums
                         
 
    2007     2006     2005  
 
Gross premiums
   $ 3,445     $ 3,405     $ 3,329  
Ceded premiums
     (852 )     (810 )     (765 )
 
 
   $ 2,593     $ 2,595     $ 2,564  
 
 
NOTE 15 OTHER LIABILITIES
                 
 
    2007     2006  
 
Short-term borrowings of subsidiaries
   $ 3,784     $ 3,929  
Payable to brokers, dealers and clients
     3,941       3,382  
Accrued interest payable
     2,908       2,556  
Accrued pension and other post-employment benefit expense (1) (refer to Note 20)
     1,266       1,250  
Insurance-related liabilities
     408       491  
Dividends payable
     661       526  
Payroll and related compensation
     3,960       3,551  
Trade payables and related accounts
     1,854       709  
Taxes payable
     1,078       78  
Other
     8,623       6,177  
 
 
   $ 28,483     $ 22,649  
 
(1)   Accrued pension and other post-employment benefit expense represents the cumulative excess of pension and other post-employment benefit expense over pension and other post-employment fund contributions.
Royal Bank of Canada: Annual Report 2007
142   Consolidated Financial Statements

 

 

 
NOTE 16 SUBORDINATED DEBENTURES
The debentures are unsecured obligations and are subordinated in right of payment to the claims of depositors and certain other creditors. All redemptions, cancellations and exchanges of subordinated debentures are subject to the consent and approval of the OSFI. All subordinated debentures are redeemable at our option. As a result of adopting the new financial instruments accounting standards effective November 1, 2006, Subordinated debentures are now presented on our Consolidated Balance Sheets net of deferred financing costs. Prior to November 1, 2006, deferred financing costs were recognized in Other assets. The prior period comparative amounts have not been restated. The amounts presented below are net of our holdings in these securities which have not been cancelled and are still outstanding.
                                                         
 
                    Interest             Denominated in              
Maturity   Earliest par value redemption date             rate             foreign currency     2007     2006  
 
March 15, 2009
                     6.50 %           US$125   $ 118     $ 140  
November 8, 2011
   November 8, 2006     (1 )                   US$400     —       449  
June 4, 2012
   June 4, 2007     (1 )     6.75 %                     —       483  
January 22, 2013
   January 22, 2008     (2 )     6.10 %     (3 )             483       497  
January 27, 2014
   January 27, 2009     (4 )     3.96 %     (3 )             495       493  
June 1, 2014
   June 1, 2009     (5 )     4.18 %     (3 )             976       997  
November 14, 2014
                     10.00 %                     257       200  
January 25, 2015
   January 25, 2010     (6 )     7.10 %     (3 )             515       495  
June 24, 2015
   June 24, 2010     (4 )     3.70 %     (3 )             775       791  
April 12, 2016
   April 12, 2011     (7 )     6.30 %     (3 )             389       400  
November 4, 2018
   November 4, 2013     (8 )     5.45 %     (3 )             1,021       985  
June 8, 2023
                     9.30 %                     110       110  
June 26, 2037
   June 26, 2017     (9 )     2.86 %     (10 )   JPY 10,000     77       —  
October 1, 2083
             (11 )             (12 )             224       224  
June 6, 2085
             (11 )             (13 )   US$189     179       239  
June 18, 2103
   June 18, 2009     (14 )     5.95 %     (15 )             622       600  
 
 
                                           $ 6,241     $ 7,103  
Deferred financing costs
                                             (6 )     —  
 
 
                                           $ 6,235     $ 7,103  
 
The terms and conditions of the debentures are as follows:
(1)   Redeemed on the earliest par value redemption date at par value.
 
(2)   Redeemable at any time prior to the earliest par value redemption date at the greater of (i) the fair value of the subordinated debentures based on the yield on Government of Canada bonds plus 18 basis points and (ii) par value, and thereafter at any time at par value.
 
(3)   Interest at stated interest rate until earliest par value redemption date, and thereafter at a rate of 1.00% above the 90-day Bankers’ Acceptance rate.
 
(4)   Redeemable at any time prior to the earliest par value redemption date at the greater of (i) the fair value of the subordinated debentures based on the yield on Government of Canada bonds plus 8 basis points and (ii) par value, and thereafter at any time at par value.
 
(5)   Redeemable at any time prior to the earliest par value redemption date at the greater of (i) the fair value of the subordinated debentures based on the yield on Government of Canada bonds plus 9 basis points and (ii) par value, and thereafter at any time at par value.
 
(6)   Redeemable at any time prior to the earliest par value redemption date at the greater of (i) the fair value of the subordinated debentures based on the yield on Government of Canada bonds plus 12.5 basis points and (ii) par value, and thereafter at any time at par value.
 
(7)   Redeemable at any time prior to the earliest par value redemption date at the greater of (i) the fair value of the subordinated debentures based on the yield on Government of Canada bonds plus 22 basis points and (ii) par value, and thereafter at any time at par value.
 
(8)   Redeemable at any time prior to the earliest par value redemption date at the greater of (i) the fair value of the subordinated debentures based on the yield on Government of Canada bonds plus 14 basis points and (ii) par value, and thereafter at any time at par value.
 
(9)   Redeemable on or after June 26, 2017, at par value
 
(10)   Fixed interest rate at 2.86% per annum, payable semi-annually.
 
(11)   Redeemable on any interest payment date at par value.
 
(12)   Interest at a rate of 40 basis points above the 30-day Bankers’ Acceptance rate.
 
(13)   Interest at a rate of 25 basis points above the U.S. dollar 3-month LIMEAN. In the event of a reduction of the annual dividend we declare on our common shares, the interest payable on the debentures is reduced pro rata to the dividend reduction and the interest reduction is payable with the proceeds from the sale of newly issued common shares.
 
(14)   Redeemable on June 18, 2009, or every fifth anniversary of such date at par value. Redeemable on any other date at the greater of par and the yield on a non-callable Government of Canada bond plus 21 basis points if redeemed prior to June 18, 2014, or 43 basis points if redeemed at any time after June 18, 2014.
 
(15)   Interest at a rate of 5.95% until earliest par value redemption date and every 5 years thereafter at the 5-year Government of Canada yield plus 172 basis points.
Maturity schedule
The aggregate maturities of subordinated debentures, based on the maturity dates under the terms of issue, are as follows
         
 
At October 31, 2007   Total  
 
Within 1 year
   $ —  
1 to 5 years
     118  
5 to 10 years
     3,890  
Thereafter
     2,233  
 
 
   $ 6,241  
 
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements   143

 

 

NOTE 17 TRUST CAPITAL SECURITIES
We issue innovative capital instruments, RBC Trust Capital Securities (TruCS) and RBC Trust Subordinated Notes (TSNs), through three SPEs: RBC Capital Trust (Trust), RBC Capital Trust II (Trust II) and RBC Subordinated Notes Trust (Trust III).
     On April 30, 2007, we issued $1 billion innovative subordinated debentures, TSNs—Series A, through Trust III. Trust III is a closed-end trust established under the laws of the Province of Ontario. The issue was priced at $99.982 with a yield to April 30, 2012 of 4.584%. The proceeds were used to purchase a senior deposit note from us. Trust III is a VIE under AcG-15. We do not consolidate Trust III as we are not its Primary Beneficiary (refer to Note 6); therefore, the TSNs—Series A issued by Trust III are not reported on our Consolidated Balance Sheet but the senior deposit note issued by us to Trust III is reported as a Business and government deposit liability (refer to Note 13).
     In prior years, we issued non-voting RBC Trust Capital Securities Series 2010, 2011 and 2015 (RBC TruCS 2010, 2011 and 2015) through our consolidated subsidiary RBC Capital Trust, a closed-end trust established under the laws of the Province of Ontario. RBC TruCS 2010 and 2011 are classified as Trust capital securities. The proceeds of the RBC TruCS 2010 and 2011 were used to fund the Trust’s acquisition of trust assets. Holders of RBC TruCS 2010 and 2011 are eligible to receive semi-annual non-cumulative fixed cash distributions.
     Unlike the RBC TruCS 2010 and 2011, the holders of RBC TruCS 2015 do not have any conversion rights or any other redemption rights.
     As a result, upon consolidation of the Trust, RBC TruCS 2015 are classified as Non-controlling interest in subsidiaries (refer to Note 19). Holders of RBC TruCS 2015 are eligible to receive semi-annual non-cumulative fixed cash distributions until December 31, 2015 and a floating-rate cash distribution thereafter.
     Trust II, an open-end trust, has issued non-voting RBC TruCS 2013, the proceeds of which were used to purchase a senior deposit note from us. Trust II is a VIE under AcG-15 (refer to Note 6). We do not consolidate Trust II as we are not the Primary Beneficiary; therefore, the RBC TruCS 2013 issued by Trust II are not reported on our Consolidated Balance Sheets, but the senior deposit note is reported in Deposits (refer to Note 13). Holders of RBC TruCS 2013 are eligible to receive semi-annual non-cumulative fixed cash distributions.
     No cash distributions will be payable by the trusts on TruCS if we fail to declare regular dividends (i) on our preferred shares, or (ii) on our common shares if no preferred shares are then outstanding. In this case, the net distributable funds of the trusts will be distributed to us as holders of residual interest in the trusts. Should the trusts fail to pay the semi-annual distributions in full, we will not declare dividends of any kind on any of our preferred or common shares for a specified period of time.
     The table below presents the significant terms and conditions of TruCS and TSNs as at October 31, 2007 and 2006:
                                                         
 
                            Redemption date   Conversion date   2007     2006  
            Annual   At the option of   At the option of   Principal     Principal  
Issuer   Issuance date   Distribution dates   yield   the issuer   the holder   amount     amount  
 
RBC Capital Trust (1), (2), (3), (4), (5), (6), (7)
                                                        
Included in Trust capital securities
                                                        
650,000 Trust Capital Securities – Series 2010
   July 24, 2000   June 30, December 31     7.288%   December 31, 2005   December 31, 2010   $ 650     $ 650  
750,000 Trust Capital Securities – Series 2011
   December 6, 2000   June 30, December 31     7.183%   December 31, 2005   December 31, 2011   $ 750     $ 750  
 
 
                                           $ 1,400     $ 1,400  
Included in Non-controlling interest in subsidiaries 1,200,000 Trust Capital Securities – Series 2015
   October 28, 2005   June 30, December 31     4.87%(8)   December 31, 2010   Holder does not
have conversion
option		   $ 1,200     $ 1,200  
 
 
                                           $ 2,600     $ 2,600  
 
RBC Capital Trust II (2), (3), (4), (6), (7), (9)
                                      
900,000 Trust Capital Securities – Series 2013
   July 23, 2003   June 30, December 31     5.812%   December 31, 2008   Anytime   $ 900     $ 900  
 
RBC Subordinated Notes Trust (3), (4), (6), (7), (10),(11)
                                                        
$1 billion 4.58% Trust Subordinated Notes – Series A
   April 30, 2007   April 30, October 30     4.584%   Anytime Holder does not have
conversion option		   $ 1,000     $ —  
 
The significant terms and conditions of the TruCS and TSNs are as follows:
(1)   Subject to the approval of the OSFI, the Trust may, in whole (but not in part), on the Redemption date specified above, and on any Distribution date thereafter, redeem the RBC TruCS 2010, 2011 and 2015, without the consent of the holders.
 
(2)   Subject to the approval of the OSFI, upon occurrence of a special event as defined, prior to the Redemption date specified above, the trusts may redeem all, but not part of, RBC TruCS 2010, 2011, 2013 or 2015 without the consent of the holders.
 
(3)   Issuer Redemption Price: The RBC TruCS 2010 and 2011 may be redeemed for cash equivalent to (i) the Early Redemption Price if the redemption occurs earlier than six months prior to the conversion date specified above or (ii) the Redemption Price if the redemption occurs on or after the date that is six months prior to the conversion date as indicated above. The RBC TruCS 2013 and 2015 may be redeemed for cash equivalent to (i) the Early Redemption Price if the redemption occurs prior to December 31, 2013 and 2015, respectively, or (ii) the Redemption Price if the redemption occurs on or after December 31, 2013 and 2015, respectively. The TSNs — Series A may be redeemed, in whole or in part, subject to the approval of the OSFI, for cash equivalent to (i) the Early Redemption Price if the notes are redeemed prior to April 30, 2012, or (ii) the Redemption Price if the notes are redeemed on or after April 30, 2012. Redemption Price refers to an amount equal to $1,000 plus the unpaid distributions to the Redemption date. Early Redemption Price refers to an amount equal to the greater of (i) the Redemption Price and (ii) the price calculated to provide an annual yield, equal to the yield on a Government of Canada bond issued on the Redemption date with a maturity date of June 30, 2010 and 2011, plus 33 basis points and 40 basis points, for RBC TruCS 2010 and 2011, respectively, and a maturity date of December 31, 2013 and 2015, plus 23 basis points and 19.5 basis points, for RBC TruCS 2013 and 2015, respectively; and a maturity date of April 30, 2012, plus 11 basis points for TSNs—Series A.
 
(4)   Automatic Exchange Event: Without the consent of the holders, each RBC TruCS 2010, 2011, 2013 and 2015 will be exchanged automatically for 40 of our non-cumulative redeemable First Preferred Shares Series Q, R, T and Z, respectively, and each TSN — Series A will be exchanged automatically for an equal principal amount of Bank Series 10 Subordinated Notes upon occurrence of any one of the following events: (i) proceedings are commenced for our winding-up; (ii) the OSFI takes control of us; (iii) we have Tier 1 capital ratio of less than 5% or Total capital ratio of less than 8%; or (iv) the OSFI has directed us to increase our capital or provide additional liquidity and we elect such automatic exchange or we fail to comply with such direction. The First Preferred Shares Series T and Z pay semi-annual non-cumulative cash dividends and Series T is convertible at the option of the holder into a variable number of common shares.
 
(5)   From time to time, we purchase some of the innovative capital instruments and hold them on a temporary basis. As at October 31, 2007, we held $nil of RBC TruCS 2011 (2006—$17 million) and $6 million of RBC TruCS 2015 (2006 — $12 million) as treasury holdings which were deducted from regulatory capital.
 
(6)   Regulatory capital: According to the OSFI guidelines, innovative capital instruments can comprise up to 15% of net Tier 1 capital with an additional 5% eligible for Tier 2B capital. Any amount in excess of the 20% limitation is not recognized for regulatory capital purposes. TSN — Series A qualifies as Tier 2B capital. As at October 31, 2007, $3,494  million (2006 — $3,222 million) represents Tier 1 capital, $1,027 million (2006 — $249 million) represents Tier 2B capital and $6 million (2006 — $29 million) of our treasury holdings of innovative capital is deducted for regulatory capital purposes. As at October 31, 2007, none of our innovative capital instruments exceeds the OSFI’s limit of 20% (2006 — nil).
Royal Bank of Canada: Annual Report 2007
144   Consolidated Financial Statements

 

 

(7)   Holder Exchange Right: Holders of RBC TruCS 2010 and 2011 may exchange, on any Distribution date on or after the conversion date specified above, RBC TruCS 2010 and 2011 for 40 non-cumulative redeemable Bank First Preferred Shares, Series Q and Series R, respectively. Holders of RBC TruCS 2013 may, at any time, exchange all or part of their holdings for 40 non-cumulative redeemable First Preferred Shares Series U, for each RBC TruCS 2013 held. The First Preferred Shares Series Q, R and U pay semi-annual non-cumulative cash dividends as and when declared by our Board of Directors and are convertible at the option of the holder into a variable number of common shares. Holders of RBC TruCS 2015 and TSNs — Series A do not have similar exchange rights.
 
(8)   The non-cumulative cash distribution on the RBC TruCS 2015 will be 4.87% paid semi-annually until December 31, 2015, and at one half of the sum of 180-day Bankers’ Acceptance rate plus 1.5%, thereafter.
 
(9)   Subject to the approval of the OSFI, Trust II may, in whole or in part, on the Redemption date specified above, and on any Distribution date thereafter, redeem any outstanding RBC TruCS 2013, without the consent of the holders.
 
(10)   The cash distribution on the TSNs — Series A will be 4.58% paid semi annually until April 30, 2012, and at 90-day Bankers’ Acceptance rate plus 1% thereafter paid quarterly until their maturity on April 30, 2017.
 
(11)   We will guarantee the payment of principal, interest, the redemption price, if any, and any other amounts of the TSNs — Bankers’ Series A when they become due and payable, whether at stated maturity, call for redemption, Automatic Exchange or otherwise according to the terms of the Bank Subordinated Guarantee and the Trust Indenture.
NOTE 18 PREFERRED SHARE LIABILITIES AND SHARE CAPITAL
Authorized share capital
Preferred — An unlimited number of First Preferred Shares and Second Preferred Shares without nominal or par value, issuable in series; the aggregate consideration for which all the First Preferred Shares and all the Second Preferred Shares that may be issued may not exceed $20 billion and $5 billion, respectively.
Common — An unlimited number of shares without nominal or par value may be issued.
Issued and outstanding shares
                                                                         
 
    2007             2006     2005  
    Number             Dividends     Number             Dividends     Number             Dividends  
    of shares             declared     of shares             declared     of shares             declared  
    (000s)     Amount     per share     (000s)     Amount     per share     (000s)     Amount     per share  
 
Preferred share liabilities
                                                                        
First preferred
                                                                        
Non-cumulative Series N
     11,916     $ 298     $ 1.18       12,000     $ 300     $ 1.18       12,000     $ 300     $ 1.18  
Treasury shares — sales
     152       4               —       —               —       —          
Treasury shares — purchases
     (68 )     (2 )             (84 )     (2 )             —       —          
 
Preferred share liabilities, net of treasury holdings
     12,000     $ 300               11,916     $ 298               12,000     $ 300          
 
Preferred shares
                                                                        
First preferred
                                                                        
Non-cumulative Series O (1)
     —     $ —     $ —       6,000     $ 150     $ 1.38       6,000     $ 150     $ 1.38  
Non-cumulative Series S (2)
     —       —       —       —       —       1.33       10,000       250       1.53  
Non-cumulative Series W (3)
     12,000       300       1.23       12,000       300       1.23       12,000       300       .99  
Non-cumulative Series AA (4)
     12,000       300       1.11       12,000       300       .71       —       —       —  
Non-cumulative Series AB (5)
     12,000       300       1.18       12,000       300       .41       —       —       —  
Non-cumulative Series AC (6)
     8,000       200       1.22       —       —       —       —       —       —  
Non-cumulative Series AD (7)
     10,000       250       1.06       —       —       —       —       —       —  
Non-cumulative Series AE (8)
     10,000       250       .95       —       —       —       —       —       —  
Non-cumulative Series AF (9)
     8,000       200       .77       —       —       —       —       —       —  
Non-cumulative Series AG (10)
     10,000       250       .65       —       —       —       —       —       —  
 
 
           $ 2,050                     $ 1,050                     $ 700          
 
Common shares
                                                                        
Balance at beginning of year
     1,280,890     $ 7,196               1,293,502     $ 7,170               1,289,496     $ 6,988          
Issued under the stock option plan (11)
     7,215       170               5,617       127               9,917       214          
Purchased for cancellation
     (11,845 )     (66 )             (18,229 )     (101 )             (5,911 )     (32 )        
 
Balance at end of year
     1,276,260     $ 7,300     $ 1.82       1,280,890     $ 7,196     $ 1.44       1,293,502     $ 7,170     $ 1.18  
 
Treasury shares — Preferred shares
                                                                        
Balance at beginning of year
     (94 )   $ (2 )             (91 )   $ (2 )             —     $ —          
Sales
     1,345       33               2,082       51               —       —          
Purchases
     (1,500 )     (37 )             (2,085 )     (51 )             (91 )     (2 )        
 
Balance at end of year
     (249 )   $ (6 )             (94 )   $ (2 )             (91 )   $ (2 )        
 
Treasury shares — Common shares
                                                                        
Balance at beginning of year
     (5,486 )   $ (180 )             (7,053 )   $ (216 )             (9,726 )   $ (294 )        
Sales
     4,756       175               5,097       193               5,904       179          
Purchases
     (1,714 )     (96 )             (3,530 )     (157 )             (1,326 )     (47 )        
Initial adoption of AcG-15
     —       —               —       —               (1,905 )     (54 )        
 
Balance at end of year
     (2,444 )   $ (101 )             (5,486 )   $ (180 )             (7,053 )   $ (216 )        
 
(1)   On November 24, 2006, we redeemed Non-cumulative First Preferred Shares Series O. The excess of the redemption price over carrying value of $3 million was charged to retained earnings in preferred share dividends.
 
(2)   On October 6, 2006, we redeemed Non-cumulative First Preferred Shares Series S. The excess of the redemption price over carrying value of $10 million was charged to retained earnings in preferred share dividends.
 
(3)   On January 31, 2005, we issued 12 million Non-cumulative First Preferred Shares Series W at $25 per share.
 
(4)   On April 4, 2006, we issued 12 million Non-cumulative First Preferred Shares Series AA at $25 per share.
 
(5)   On July 20, 2006, we issued 12 million Non-cumulative First Preferred Shares Series AB at $25 per share.
 
(6)   On November 1, 2006, we issued 8 million Non-cumulative First Preferred Shares Series AC at $25 per share.
 
(7)   On December 13, 2006, we issued 10 million Non-cumulative First Preferred Shares Series AD at $25 per share.
 
(8)   On January 19, 2007, we issued 10 million Non-cumulative First Preferred Shares Series AE at $25 per share.
 
(9)   On March 14, 2007, we issued 8 million Non-cumulative First Preferred Shares Series AF at $25 per share.
 
(10)   On April 26, 2007, we issued 10 million Non-cumulative First Preferred Shares Series AG at $25 per share.
 
(11)   Includes the exercise of stock options from tandem stock appreciation rights (SARs) awards, resulting in a reversal of the accrued liability, net of related income taxes, of $10 million (2006 — $8 million), and from renounced tandem SARs, net of related income taxes, of $6 million (2006 — $2 million).
     Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements 145

 

 

NOTE 18 PREFERRED SHARE LIABILITIES AND SHARE CAPITAL (CONTINUED)
Terms of preferred share liabilities and preferred shares
                                         
 
                            Conversion date  
    Dividend     Redemption     Redemption     At the option of     At the option of  
    per share (1)     date (2)     price (2), (3)     the bank (2), (4)     the holder (5)  
 
Preferred share liabilities
                                        
First preferred
                                        
Non-cumulative Series N
   $ .293750     August 24, 2003   $ 25.00     August 24, 2003   August 24, 2008
 
Preferred shares
                                        
First preferred
   $ .306250     February 24, 2010   $ 26.00     February 24, 2010   Not convertible
Non-cumulative Series W
                                        
Non-cumulative Series AA
     .278125     May 24, 2011     26.00     Not convertible   Not convertible
Non-cumulative Series AB
     .293750     August 24, 2011     26.00     Not convertible   Not convertible
Non-cumulative Series AC
     .287500     November 24, 2011     26.00     Not convertible   Not convertible
Non-cumulative Series AD
     .281250     February 24, 2012     26.00     Not convertible   Not convertible
Non-cumulative Series AE
     .281250     February 24, 2012     26.00     Not convertible   Not convertible
Non-cumulative Series AF
     .278125     May 24, 2012     26.00     Not convertible   Not convertible
Non-cumulative Series AG
     .281250     May 24, 2012     26.00     Not convertible   Not convertible
 
(1)   Non-cumulative preferential dividends on Series N, W, AA, AB, AC, AD, AE, AF and AG are payable quarterly, as and when declared by the Board of Directors, on or about the 24th day of February, May, August and November.
 
(2)   The redemption price represents the price as at October 31, 2007 or the contractual redemption price, whichever is applicable. Subject to the consent of the OSFI and the requirements of the Act, we may, on or after the dates specified above, redeem First Preferred Shares. These may be redeemed for cash, in the case of Series N at a price per share of $26, if redeemed during the 12 months commencing August 24, 2003, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after August 24, 2007; and in the case of Series W, at a price per share of $26, if redeemed during the 12 months commencing February 24, 2010, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after February 24, 2014; and in the case of Series AA, at a price per share of $26, if redeemed during the 12 months commencing May 24, 2011, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after May 24, 2015; and in the case of Series AB, at a price per share of $26, if redeemed during the 12 months commencing August 24, 2011, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after August 24, 2015; and in the case of Series AC, at a price per share of $26, if redeemed during the 12 months commencing November 24, 2011, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after November 24, 2015; and in the case of Series AD, at a price per share of $26, if redeemed during the 12 months commencing February 24, 2012, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after February 24, 2016; and in the case of Series AE, at a price per share of $26, if redeemed during the 12 months commencing February 24, 2012, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after February 24, 2016; and in the case of Series AF, at a price per share of $26, if redeemed during the 12 months commencing May 24, 2012, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after May 24, 2016; and in the case of Series AG, at a price per share of $26, if redeemed during the 12 months commencing May 24, 2012, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after May 24, 2016.
 
(3)   Subject to the consent of the OSFI and the requirements of the Act, we may purchase the First Preferred Shares Series N, W, AA, AB, AC, AD, AE, AF and AG for cancellation at the lowest price or prices at which, in the opinion of the Board of Directors, such shares are obtainable.
 
(4)   Subject to the approval of the Toronto Stock Exchange, we may, on or after the dates specified above, convert First Preferred Shares Series N and W into our common shares. First Preferred Shares may be converted into that number of common shares determined by dividing the then-applicable redemption price by the greater of $2.50 and 95% of the weighted average trading price of common shares at such time.
 
(5)   Subject to our right to redeem or to find substitute purchasers, the holder may, on or after the dates specified above, convert First Preferred Shares into our common shares. Series N may be converted, quarterly, into that number of common shares determined by dividing the then-applicable redemption price by the greater of $2.50 and 95% of the weighted average trading price of common shares at such time.
Restrictions on the payment of dividends
We are prohibited by the Act from declaring any dividends on our preferred or common shares when we are, or would be placed as a result of the declaration, in contravention of the capital adequacy and liquidity regulations or any regulatory directives issued under the Act. We may not pay dividends on our common shares at any time unless all dividends to which preferred shareholders are then entitled have been declared and paid or set apart for payment.
     In addition, we may not declare or pay a dividend without the approval of the OSFI if, on the day the dividend is declared, the total of all dividends in that year would exceed the aggregate of our net income up to that day and of our retained net income for the preceding two years.
     We have agreed that if RBC Capital Trust or RBC Capital Trust II fail to pay any required distribution on the trust capital securities in full, we will not declare dividends of any kind on any of our preferred or common shares. Refer to Note 17.
     Currently, these limitations do not restrict the payment of dividends on our preferred or common shares.
     We have also agreed that if, on any day we report financial results for a quarter, (i) we report a cumulative consolidated net loss for the immediately preceding four quarters; and (ii) during the immediately preceding quarter we fail to declare any cash dividends on all of our outstanding preferred and common shares, we may defer payments of interest on the Series 2014-1 Reset Subordinated Notes (matures on June 18, 2103). During any period while interest is being deferred, (i) interest will accrue on these notes but will not compound; (ii) we may not declare or pay dividends (except by way of stock dividend) on, or redeem or repurchase, any of our preferred or common shares; and (iii) we may not make any payment of interest, principal or premium on any debt securities or indebtedness for borrowed money issued or incurred by us that rank subordinate to these notes.
Regulatory capital
We are subject to the regulatory capital requirements defined by the OSFI. Two measures of capital strength established by the OSFI, based on standards issued by the Bank for International Settlements, are risk-adjusted capital ratios and the assets-to-capital multiple.
     The OSFI requires Canadian banks to maintain a minimum Tier 1 and Total capital ratio of 4% and 8%, respectively. However, the OSFI has also formally established risk-based capital targets for deposit-taking institutions in Canada. These targets are a Tier 1 capital ratio of
Royal Bank of Canada: Annual Report 2007
146  Consolidated Financial Statements

 

 

7% and a Total capital ratio of 10%. At October 31, 2007, our Tier 1 and Total capital ratios were 9.4% and 11.5%, respectively (2006 — 9.6% and 11.9%, respectively).
     As at October 31, 2007, our assets-to-capital multiple was 19.9 (2006 — 19.7), which remains below the maximum ratio of 23 permitted by the OSFI.
Dividend reinvestment plan
Our dividend reinvestment plan (plan), which was announced on August 27, 2004, provides registered common shareholders with a means to automatically reinvest the cash dividends paid on their common shares in the purchase of additional common shares. The plan is only open to registered shareholders residing in Canada or the United States.
     Management has the flexibility to fund the plan through open market share purchases or treasury issuances.
Shares available for future issuances
As at October 31, 2007, 36.6 million common shares are available for future issue relating to our plan and potential exercise of stock options outstanding.
Normal Course Issuer Bid
Details of common shares repurchased under Normal Course Issuer Bids (NCIB) during 2007, 2006 and 2005 are given below.
                                 
 
    2007  
    Number of     Number of              
    shares eligible     shares     Average        
    for repurchase     repurchased     cost        
NCIB period   (000s)     (000s)     per share     Amount  
 
November 1, 2006 — October 31, 2007
     40,000       11,845     $ 54.59     $ 646  
 
                                                                 
 
    2006  
            Pre-stock dividend     Post-stock dividend     Total  
    Number of shares     Number of                     Number of                      
    eligible for     shares     Average             shares     Average                
    repurchase     repurchased     cost             repurchased     cost                
NCIB period   (000s)     (000s)     per share     Amount     (000s)     per share     Amount        
 
June 26, 2006 — October 31, 2006
     7,000       —     $ —     $ —       6,595     $ 47.12     $ 311     $ 311  
June 24, 2005 — June 23, 2006
     10,000       4,387       90.48       397       2,859       47.52       136       533  
 
 
             4,387     $ 90.48     $ 397       9,454     $ 47.24     $ 447     $ 844  
 
                                 
    2005 (1)  
    Number of shares     Number of              
    eligible for     shares     Average        
    repurchase     repurchased     cost        
NCIB period   (000s)     (000s)     per share     Amount  
 
June 24, 2005 — June 23, 2006
     10,000       1,950     $ 83.50     $ 163  
June 24, 2004 — June 23, 2005
     25,000       1,005       63.24       63  
 
 
             2,955     $ 76.61     $ 226  
 
(1)   The 2005 number of shares and average cost per share are pre-stock dividend.
NOTE 19 NON-CONTROLLING INTEREST IN SUBSIDIARIES
                 
 
    2007     2006  
 
RBC Trust Capital Securities (TruCS) Series 2015
   $ 1,214     $ 1,207  
Consolidated VIEs
     188       506  
Others
     81       62  
 
 
   $ 1,483     $ 1,775  
 
We consolidate VIEs in which we are the Primary Beneficiary. These VIEs include structured finance VIEs, investment funds, credit investment product VIEs and compensation vehicles as described in Note 6.
     We issued RBC TruCS 2015 in 2005 which are reported as Non-controlling interest in subsidiaries upon consolidation as discussed in Note 17. As at October 31, 2007, $20 million (2006 — $19 million) of accrued interest net of $6 million (2006 — $12 million) of treasury holdings was included in RBC Trust Capital Securities Series 2015.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  147

 

 

NOTE 20 PENSIONS AND OTHER POST-EMPLOYMENT BENEFITS
We offer a number of defined benefit and defined contribution plans, which provide pension and post-employment benefits to eligible employees. Our defined benefit pension plans provide benefits based on years of service, contributions and average earnings at retirement. Our other post-employment benefit plans include health, dental, disability and life insurance coverage.
     During 2006, we changed our post-retirement benefit program in Canada. The changes reduced our benefit obligations by $505 million.
     We fund our registered defined benefit pension plans in accordance with actuarially determined amounts required to satisfy employee benefit obligations under current pension regulations. For our principal pension plans, the most recent actuarial valuation performed for funding purposes was completed on January 1, 2007. The next actuarial valuation for funding purposes will be completed on January 1, 2008.
     For 2007, total contributions to our pension and other post-employment benefit plans were $208 million and $57 million (2006 — $594 million and $58 million), respectively. For 2008, total contributions to defined benefit pension plans and other post-employment benefit plans are expected to be approximately $128 million and $55 million, respectively.
     For financial reporting purposes, we measure our benefit obligations and pension plan assets as at September 30 each year.
     The following tables present financial information related to all of our material pension and other post-employment plans worldwide, including executive retirement arrangements:
Plan assets, benefit obligation and funded status
                                 
 
               Pension plans (1)                Other post-employment plans (2)  
    2007     2006     2007     2006  
 
Change in fair value of plan assets
                                
Opening fair value of plan assets
   $ 6,407     $ 5,719     $ 41     $ 29  
Actual return on plan assets
     638       445       4       3  
Company contributions
     146       518       56       59  
Plan participant contributions
     25       24       5       6  
Benefits paid
     (333 )     (323 )     (54 )     (56 )
Business acquisitions
     —       21       —       —  
Other
     (34 )     2       —       —  
Change in foreign currency exchange rate
     (65 )     1       —       —  
 
Closing fair value of plan assets
   $ 6,784     $ 6,407     $ 52     $ 41  
 
Change in benefit obligation
                                
Opening benefit obligation
   $ 6,838     $ 6,524     $ 1,468     $ 1,891  
Service cost
     178       173       19       26  
Interest cost
     362       345       75       77  
Plan participant contributions
     25       24       5       6  
Actuarial (gain) loss
     (115 )     38       3       38  
Benefits paid
     (333 )     (323 )     (54 )     (56 )
Plan amendments and curtailments
     (9 )     24       —       (515 )
Business acquisitions
     5       31       —       5  
Other
     (27 )     5       —       —  
Change in foreign currency exchange rate
     (78 )     (3 )     (12 )     (4 )
 
Closing benefit obligation
   $ 6,846     $ 6,838     $ 1,504     $ 1,468  
 
Funded status
                                
Excess of benefit obligation over plan assets
   $ (62 )   $ (431 )   $ (1,452 )   $ (1,427 )
Unrecognized net actuarial loss
     488       963       564       598  
Unrecognized transitional (asset) obligation
     (10 )     (12 )     1       1  
Unrecognized prior service cost
     95       131       (307 )     (330 )
Contributions between September 30 and October 31
     2       14       5       4  
 
Prepaid asset (accrued liability) as at October 31
   $ 513     $ 665     $ (1,189 )   $ (1,154 )
 
Amounts recognized in our Consolidated Balance Sheets consist of:
                                
Other assets
   $ 590     $ 761     $ —     $ —  
Other liabilities
     (77 )     (96 )     (1,189 )     (1,154 )
 
Net amount recognized as at October 31
   $ 513     $ 665     $ (1,189 )   $ (1,154 )
 
Weighted average assumptions to calculate benefit obligation
                                
Discount rate
     5.60 %     5.25 %     5.62 %     5.26 %
Rate of increase in future compensation (3)
     3.30 %     3.30 %     3.30 %     3.30 %
 
     
(1)   For pension plans with funding deficits, the benefit obligations and fair values of plan assets totalled $5,850 million (2006—$6,156 million) and $5,687 million (2006-$5,665 million), respectively.
 
(2)   For our other post-employment plans, the assumed health care cost trend rates for the next year used to measure the expected cost of benefits covered by the post-employment health and life plans were 7.2% for medical decreasing to an ultimate rate of 5.0% in 2016 and 4.5% for dental.
 
(3)   The actual assumption for rate of increase in future compensation is an age-related scale. Although the underlying assumption has not been changed, we have revised our presentation of the disclosed equivalent single rate to be more consistent with the methodology used by other Canadian financial institutions.
The following table presents our estimates of the benefit payments for defined benefit pension and other post-employment plans:
Benefits payment projection
                 
 
            Other  
            post-employment  
    Pension plans     plans  
 
2008
   $ 318     $ 61  
2009
     349       69  
2010
     357       74  
2011
     365       77  
2012
     373       81  
2013-2017
     2,086       458  
 
Royal Bank of Canada: Annual Report 2007
148  Consolidated Financial Statements

 

 

Composition of defined benefit pension plan assets
The defined benefit pension plan assets are primarily composed of equity and fixed income securities. The equity securities include 1.5 million (2006 — 1.9 million) of our common shares having a fair value of $84 million (2006-$94 million). Dividends amounting to $2.6 million (2006 — $2.5 million) were received on our common shares held in the plan assets during the year.
     The following table presents the allocation of the plan assets by securities category:
Asset category
                 
 
    Actual  
    2007     2006  
 
Equity securities
     60 %     60 %
Debt securities
     40 %     40 %
 
Total
     100 %     100 %
 
Investment policy and strategies
Pension plan assets are invested prudently over the long term in order to meet pension obligations at a reasonable cost. The asset mix policy takes into consideration a number of factors including the following:
(i)   investment characteristics including expected returns, volatilities and correlations between plan assets and plan liabilities;
 
(ii)   the plan’s tolerance for risk, which dictates the trade-off between increased short-term volatility and enhanced long-term expected returns;
 
(iii)   diversification of plan assets to minimize the risk of large losses;
 
(iv)   the liquidity of the portfolio relative to the anticipated cash flow requirements of the plan; and
 
(v)   actuarial factors such as membership demographics and future salary growth rates.
Pension and other post-employment benefit expense
The following tables present the composition of our pension benefit and other post-employment benefit expense:
Pension benefit expense
                         
 
    2007     2006     2005  
 
Service cost
   $ 178     $ 173     $ 138  
Interest cost
     362       345       344  
Expected return on plan assets
     (411 )     (364 )     (328 )
Amortization of transitional asset
     (2 )     (2 )     (2 )
Amortization of prior service cost
     29       32       32  
Amortization of actuarial loss (gain)
     129       138       90  
Other
     7       3       3  
 
Defined benefit pension expense
   $ 292     $ 325     $ 277  
Defined contribution pension expense
     74       65       63  
 
Pension benefit expense
   $ 366     $ 390     $ 340  
 
Weighted average assumptions to calculate pension benefit expense
                        
Discount rate
     5.25 %     5.25 %     6.25 %
Assumed long-term rate of return on plan assets
     7.00 %     7.00 %     7.00 %
Rate of increase in future compensation
     3.30 %     3.30 %     3.30 %
 
Other post-employment benefit expense
                         
 
    2007     2006     2005  
 
Service cost
   $ 19     $ 26     $ 49  
Interest cost
     75       77       101  
Expected return on plan assets
     (3 )     (2 )     (2 )
Amortization of transitional obligation
     —       3       17  
Amortization of actuarial loss (gain)
     36       31       30  
Amortization of prior service cost
     (23 )     (20 )     1  
Curtailment gain
     —       (8 )     (1 )
 
Other post-employment benefit expense
   $ 104     $ 107     $ 195  
 
Weighted average assumptions to calculate other post-employment benefit expense
                        
Discount rate
     5.26 %     5.41 %     6.35 %
Rate of increase in future compensation (1)
     3.30 %     3.30 %     3.30 %
 
 
(1)   The actual assumption for rate of increase in future compensation is an age-related scale. Although the underlying assumption has not changed, we have revised our presentation of the disclosed equivalent single rate to be more consistent with the methodology used by other Canadian financial institutions.
Significant assumptions
Our methodologies to determine significant assumptions used in calculating the defined benefit pension and other post-employment expense are as follows:
Overall expected long-term rate of return on assets
The assumed expected rate of return on assets is determined by considering long-term expected returns on government bonds and a reasonable assumption for an equity risk premium. The expected long-term return for each asset class is then weighted based on the target asset allocation to develop the expected long-term rate of return on assets assumption for the portfolio. This resulted in the selection of an assumed expected rate of return of 7% for 2008 (7% for 2004 to 2007).
Discount rate
For the Canadian and U.S. pension and other post-employment plans, all future expected benefit payment cash flows at each measurement date are discounted at spot rates developed from a yield curve of AA corporate debt securities. It is assumed that spot rates beyond 30 years are equivalent to the 30-year spot rate. The discount rate is selected as the equivalent level rate that would produce the same discounted value as that determined by using the applicable spot rates. This methodology does not rely on assumptions regarding reinvestment rates.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  149

 

 

 
NOTE 20 PENSION AND OTHER POST-EMPLOYMENT BENEFITS (continued)
Sensitivity analysis
The following table presents the sensitivity analysis of certain key assumptions on defined benefit pension and post-employment obligation and expense:
2007 Sensitivity of key assumptions
                 
 
    Change in     Change in  
Pension   obligation     expense  
 
Impact of .25% change in discount rate assumption
   $ 229     $ 29  
Impact of .25% change in rate of increase in future compensation assumption
     23       6  
Impact of .25% change in the long-term rate of return on plan assets assumption
     —       15  
 
                 
 
    Change in     Change in  
Other post-employment   obligation     expense  
 
Impact of .25% change in discount rate assumption
   $ 55     $ 10  
Impact of .25% change in rate of increase in future compensation assumption
     —       —  
Impact of 1.00% increase in health care cost trend rates
     157       9  
Impact of 1.00% decrease in health care cost trend rates
     (129 )     (7 )
 
Reconciliation of defined benefit expense recognized with defined benefit expense incurred
The cost of pension and other post-employment benefits earned by employees is actuarially determined using the projected benefit method pro-rated on services. The cost is computed using the discount rate determined in accordance with the methodology described in significant assumptions, and is based on management’s best estimate of expected plan investment performance, salary escalation, retirement ages of employees and costs of health, dental, disability and life insurance.
     Actuarial gains or losses arise over time due to differences in actual experience compared to actuarial assumptions. Prior service costs arise as a result of plan amendments. Adoption of CICA Handbook Section 3461, Employee Future Benefits, resulted in recognition of a transitional asset and obligation at the date of adoption.
     The actuarial gains or losses, prior service costs and transitional asset or obligation are amortized over the expected average remaining service lifetime of active members expected to receive benefits under the plan. The following tables show the impact on our annual benefit expense if we had recognized all costs and expenses as they arose.
Defined benefit pension expense incurred
                         
 
    2007     2006     2005  
 
Defined benefit pension expense recognized
   $ 292     $ 325     $ 277  
Difference between expected and actual return on plan assets
     (227 )     (81 )     (423 )
Difference between actuarial losses (gains) amortized and actuarial losses (gains) arising
     (246 )     (100 )     708  
Difference between prior service costs amortized and prior service costs arising
     (38 )     (2 )     (31 )
Amortization of transitional asset
     2       2       2  
 
Defined benefit pension expense incurred
   $ (217 )   $ 144     $ 533  
 
Other post-employment benefit expense incurred
                         
 
    2007     2006     2005  
 
Other post-employment benefit expense recognized
   $ 104     $ 107     $ 195  
Difference between expected and actual return on plan assets
     (1 )     (1 )     (2 )
Difference between actuarial losses (gains) amortized and actuarial losses (gains) arising
     (33 )     7        150  
Difference between prior service costs amortized and prior service costs arising
     23       (485 )     (1 )
Amortization of transitional obligation
     —       (3 )     (17 )
 
Other post-employment benefit expense incurred
   $ 93     $ (375 )   $ 325  
 
 
NOTE 21 STOCK-BASED COMPENSATION
We offer stock-based compensation to certain key employees and to our non-employee directors. We use derivatives and compensation trusts to manage our economic exposure to volatility in the price of our common shares under many of these plans. The stock-based compensation amounts recorded in Non-interest expense — Human resources in our Consolidated Statements of Income are net of the impact of these derivatives.
Stock option plans
We have stock option plans for certain key employees and for non-employee directors. On November 19, 2002, the Board of Directors discontinued all further grants of options under the non-employee directors plan. Under the employee stock option plan, options are periodically granted to purchase common shares. The exercise price for each grant is determined as the higher of the volume-weighted average of the trading prices per board lot (100 shares) of our common shares on the Toronto Stock Exchange (i) on the day preceding the day of grant; and (ii) the five consecutive trading days immediately preceding the day of grant. Stock options are normally granted at the end of the year, with the exercise price determined at least five business days after the release of the year-end financial results. The options vest over a four-year period for employees and are exercisable for a period not exceeding 10 years from the grant date.
     For options issued prior to November 1, 2002, that were not accompanied by tandem stock appreciation rights (SARs), no compensation expense was recognized as the option’s exercise price was not less than the market price of the underlying stock on the day of grant. When the options are exercised, the proceeds received are credited to common shares.
     Between November 29, 1999 and June 5, 2001, grants of options under the employee stock option plan were accompanied by tandem SARs. With tandem SARs, participants could choose to exercise a SAR instead of the corresponding option. In such cases, the participants received a cash payment equal to the difference between the closing price of common shares on the day immediately preceding the day of exercise and the exercise price of the option. During the last quarter of
Royal Bank of Canada: Annual Report 2007
150  Consolidated Financial Statements

 

 

2002 and first quarter of 2003, certain executive participants voluntarily renounced their SARs while retaining the corresponding options. SARs obligations are now fully vested and give rise to compensation expense as a result of changes in the market price of our common shares. The compensation expense for these grants, which are accompanied by tandem SARs, was $19 million for the year ended October 31, 2007 (2006 — $27 million; 2005 — $42 million).
A summary of our stock option activity and related information
                                                 
 
    2007     2006     2005  
    Number     Weighted     Number     Weighted     Number     Weighted  
    of options     average     of options     average     of options     average  
    (000s)     exercise price     (000s)     exercise price     (000s)     exercise price  
 
Outstanding at beginning of year
     32,243     $ 24.66       36,481     $ 23.15       44,744     $ 22.02  
Granted
     1,835       55.06       1,756       44.13       2,054       31.70  
Exercised — Common shares (1), (2)
     (7,215 )     21.10       (5,617 )     20.40       (9,917 )     19.85  
— SARs
     (204 )     21.50       (143 )     21.60       (320 )     21.01  
Cancelled
     (36 )     36.42       (234 )     24.36       (80 )     30.44  
 
Outstanding at end of year
     26,623     $ 27.71       32,243     $ 24.66       36,481     $ 23.15  
 
Exercisable at end of year
     21,924     $ 24.17       26,918     $ 22.57       28,863     $ 21.56  
Available for grant
     21,527               23,121               24,500          
 
(1)   Cash received for options exercised during the year was $152 million (2006 — $115 million; 2005 — $197 million).
 
(2)   New shares were issued for all options exercised in 2007, 2006 and 2005. Refer to Note 18.
Options outstanding and options exercisable as at October 31, 2007 by range of exercise price
                                         
 
    Options outstanding     Options exercisable  
                    Weighted              
    Number     Weighted     average     Number     Weighted  
    outstanding     average     remaining     exercisable     average  
    (000s)     exercise price     contractual life     (000s)     exercise price  
 
$8.47   — $8.91(1)
     393     $ 8.76       2.0       393     $ 8.76  
$15.00 — $19.82
     6,071       17.75       1.5       6,071       17.75  
$21.79 — $25.00
     9,533       24.58       3.4       9,533       24.58  
$26.10 — $31.70
     7,062       30.42       5.6       5,501       30.09  
$44.13 — $57.90
     3,564       49.75       8.6       426       44.13  
 
Total
     26,623     $ 27.71       4.2       21,924     $ 24.17  
 
(1)   The weighted average exercise prices have been revised to reflect the conversion of foreign currency- denominated options at the exchange rate as at our Consolidated Balance Sheet date.
Fair value method
CICA 3870 requires recognition of an expense for option awards using the fair value method of accounting. Under this method, the fair value of an award at the grant date is amortized over the applicable vesting period and recognized as compensation expense. We adopted the fair value method of accounting prospectively for new awards granted after November 1, 2002. The fair value compensation expense recorded for the year ended October 31, 2007, in respect of these plans was $13 million (2006 — $13 million; 2005 — $14 million). The compensation expenses related to non-vested awards were $14 million at October 31, 2007 (2006 — $13 million; 2005 — $16 million), to be recognized over the weighted average period of 2.2 years (2006 — 2.0 years; 2005 — 1.7 years).
     CICA 3870 permits the use of other recognition methods, including the intrinsic value method, provided pro forma disclosures of net income and earnings per share calculated in accordance with the fair value method are presented. For awards granted before November 1, 2002, pro forma net income and earnings per share are presented in the following table.
                                 
 
    As reported     Pro forma (1), (2)  
    2007     2006     2005     2005  
 
Net income from continuing operations
   $ 5,492     $ 4,757     $ 3,437     $ 3,424  
Net loss from discontinued operations (3)
     —       (29 )     (50 )     (50 )
 
Net income
   $ 5,492     $ 4,728     $ 3,387     $ 3,374  
 
Basic earnings (loss) per share
                                
From continuing operations
   $ 4.24     $ 3.67     $ 2.65     $ 2.64  
From discontinued operations
     —       (.02 )     (.04 )     (.04 )
 
Total
   $ 4.24     $ 3.65     $ 2.61     $ 2.60  
 
Diluted earnings (loss) per share
From continuing operations
   $ 4.19     $ 3.61     $ 2.61     $ 2.60  
From discontinued operations
     —       (.02 )     (.04 )     (.04 )
 
Total
   $ 4.19     $ 3.59     $ 2.57     $ 2.56  
 
(1)   Compensation expense under the fair value method is recognized over the vesting period of the related stock options. Accordingly, the pro forma results of applying this method may not be indicative of future amounts.
 
(2)   During the first quarter of 2006, all awards granted prior to adopting the fair value method of accounting were fully vested and their fair values at the grant dates had been fully amortized; therefore, there are no pro forma results to disclose for the year ended October 31, 2007 and 2006.
 
(3)   Refer to Note 11.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  151

 

 

 
NOTE 21 STOCK-BASED COMPENSATION (continued)
The weighted average fair value of options granted during 2007 was estimated at $7.84 (2006 — $6.80; 2005 — $4.66) using an option pricing model on the date of grant. The following assumptions were used:
                         
 
For the year ended October 31   2007     2006     2005  
 
Weighted average assumptions
                        
Risk-free interest rate
     3.82 %     3.98 %     3.75 %
Expected dividend yield
     3.06 %     3.16 %     3.25 %
Expected share price volatility
     16 %     17 %     17 %
Expected life of option
   6 years   6 years   6 years
 
Employee savings and share ownership plans
We offer many employees an opportunity to own our shares through savings and share ownership plans. Under these plans, the employees can generally contribute between 1% and 10% of their annual salary or benefit base for commissioned employees. For each contribution between 1% and 6%, we will match 50% of the employee contributions in our common shares. For the RBC Dominion Securities Savings Plan our maximum annual contribution is $4,500 per employee. For the RBC U.K. Share Incentive Plan our maximum annual contribution is £1,500 per employee. In 2007, we contributed $64 million (2006 — $60 million; 2005 — $56 million), under the terms of these plans, towards the purchase of our common shares. As at October 31, 2007, an aggregate of 34.4 million common shares were held under these plans.
Deferred share and other plans
We offer deferred share unit plans to executives, non-employee directors and to certain key employees. Under these plans, the executives or directors may choose to receive all or a percentage of their annual variable short-term incentive bonus or directors’ fee in the form of deferred share units (DSUs). The executives or directors must elect to participate in the plan prior to the beginning of the year. DSUs earn dividend equivalents in the form of additional DSUs at the same rate as dividends on common shares. The participant is not allowed to convert the DSUs until retirement, permanent disability or termination of employment/directorship. The cash value of the DSUs is equivalent to the market value of common shares when conversion takes place. The value of the DSUs liability as at October 31, 2007, was $285 million (2006 — $232 million; 2005 — $172 million). The share price fluctuations and dividend equivalents compensation expense recorded for the year ended October 31, 2007, in respect of these plans was $37 million (2006 — $45 million; 2005 — $42 million).
     We have a deferred bonus plan for certain key employees within Capital Markets. Under this plan, a percentage of each employee’s annual incentive bonus is deferred and accumulates dividend equivalents at the same rate as dividends on common shares. The employee will receive the deferred bonus in equal amounts paid within 90 days of the three following year-end dates. The value of the deferred bonus paid will be equivalent to the original deferred bonus adjusted for dividends and changes in the market value of common shares at the time the bonus is paid. The value of the deferred bonus liability as at October 31, 2007, was $490 million (2006 — $401 million; 2005 — $320 million). The share price fluctuations and dividend equivalents compensation expense for the year ended October 31, 2007, in respect of this plan was $62 million (2006 — $51 million; 2005 — $57 million).
     We offer performance deferred share award plans to certain key employees, all of which vest at the end of three years. Awards under the plans are deferred in the form of common shares which are held in trust until they fully vest or in the form of DSUs. A portion of the award under some plans can be increased or decreased up to 50%, depending on our total shareholder return compared to a defined peer group of North American financial institutions. The value of the award paid will be equivalent to the original award adjusted for dividends and changes in the market value of common shares at the time the award vests. The number of our common shares held in trust as at October 31, 2007, was 2.3 million (2006 — 5.3 million; 2005 — 7.3 million). The value of the DSUs liability as at October 31, 2007 was $250 million (2006 — $153 million; 2005 — $38 million). The compensation expense recorded for the year ended October 31, 2007, in respect of these plans was $168 million (2006 — $148 million; 2005 — $109 million).
     We maintain a non-qualified deferred compensation plan for key employees in the United States under an arrangement called the RBC U.S. Wealth Accumulation Plan. This plan allows eligible employees to make deferrals of a portion of their annual income and allocate the deferrals among various fund choices, which include a share unit fund that tracks the value of our common shares. Certain deferrals may also be eligible for matching contributions, all of which are allocated to the RBC share unit fund. Our liability for the RBC share units held under the plan as at October 31, 2007, was $285 million (2006 — $289 million; 2005 — $236 million). The compensation expense recorded for the year ended October 31, 2007, was $157 million (2006 — $110 million; 2005 — $90 million).
     For other stock-based plans, compensation expense of $9 million was recognized for the year ended October 31, 2007 (2006 — $10 million; 2005 — $8 million). The liability for the share units held under these plans as at October 31, 2007, was $21 million (2006 — $4 million; 2005 — $19 million). The number of our common shares held under these plans was .3 million (2006 — .3 million; 2005 — .3 million).
Royal Bank of Canada: Annual Report 2007
152  Consolidated Financial Statements

 

 

 
NOTE 22 TRADING REVENUE
Total trading revenue includes both trading-related Net interest income and trading revenue reported in Non-interest income. Net interest income arises from interest and dividends related to trading assets and liabilities and amortization of premiums and discounts arising on their acquisition or issuance. Non-interest income includes realized and unrealized gains and losses on trading securities and trading derivative financial instruments.
Trading revenue
                         
 
    2007     2006     2005  
 
Net interest income
   $ (390 )   $ (539 )   $ 21  
Non-interest income
     2,261       2,574       1,594  
 
Total
   $ 1,871     $ 2,035     $ 1,615  
 
By product line
                        
Interest rate and credit
   $ 693     $ 1,174       1,025  
Equities
     823       561       355  
Foreign exchange and commodities (1)
     355       300       235  
 
Total
   $ 1,871     $ 2,035     $ 1,615  
 
(1)   Includes precious metals.
 
NOTE 23 BUSINESS REALIGNMENT CHARGES
The following table sets out the changes in our business realignment charges since November 1, 2004. These charges are recorded in Other liabilities and include the income-protection payments for the 2,015 employees who have been terminated as of October 31, 2007. Although the majority of the initiatives were substantially completed during 2006, the associated income-protection payments to severed employees and certain lease obligations continue. Prior to 2007, the charges pertaining to RBC Mortgage were recorded in Liabilities of operations held for sale. These charges include the remaining lease obligations in connection with its former Chicago headquarters and 40 of its branches which we vacated but remain the lessee.
Business realignment charges
                         
 
    2007     2006     2005  
 
Continuing operations
                        
Balance at beginning of year
   $ 43     $ 118     $ 177  
Employee-related charges
     —       (3 )     40  
Premises-related charges
     —       3       -  
Other adjustments including foreign exchange
     —       (1 )     (5 )
Cash payments
     (35 )     (74 )     (94 )
 
Balance at end of year
   $ 8     $ 43     $ 118  
 
Discontinued operations
                        
Balance at beginning of year
   $ 14     $ 13     $ 15  
Employee-related charges
     —       —       1  
Premises-related charges
     (4 )     6       12  
Cash payments
     (3 )     (5 )     (15 )
 
Balance at end of year
   $ 7     $ 14     $ 13  
 
Employee-related
   $ 7                  
Premises-related
     8                  
 
Total
   $ 15                  
 
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  153

 

 

 
NOTE 24 INCOME TAXES
                         
 
    2007     2006     2005  
 
Income taxes in Consolidated Statements of Income
                        
Continuing operations
                        
Current
                        
Canada — Federal
   $ 696     $ 506     $ 739  
              — Provincial
     416       331       431  
International
     322       435       478  
 
 
     1,434       1,272       1,648  
 
Future
                        
Canada — Federal
     14       104       (206 )
              — Provincial
     3       31       (96 )
International
     (59 )     (4 )     (68 )
 
 
     (42 )     131       (370 )
 
Subtotal
     1,392       1,403       1,278  
 
Discontinued operations
                        
Current
                       
International
     —       (20 )     (35 )
Future
                       
International
     —       2       3  
 
Subtotal
     1,392       1,385       1,246  
 
Income taxes (recoveries) in Consolidated Statements of Comprehensive Income and Changes in Shareholders’ Equity
                        
Continuing operations
                        
Other comprehensive income (1)
                        
Net unrealized gains (losses) on available-for-sale securities
     (26 )     n.a.       n.a.  
Reclassification of (gains) losses on available-for-sale securities to income
     15       n.a.       n.a.  
Net foreign currency translation gains (losses), net of hedging activities
     911       130       204  
Net unrealized gains (losses) on derivatives designated as cash flow hedges
     43       n.a.       n.a.  
Reclassification to income of (gains) losses on derivatives designated as cash flow hedges
     16       n.a.       n.a.  
Issuance costs
     (12 )     (4 )     2  
Stock appreciation rights
     5       4       5  
Wealth accumulation plan gains
     —       —       7  
Other
     (6 )     6       2  
 
Subtotal
     946       136       220  
 
Total income taxes
   $ 2,338     $ 1,521     $ 1,466  
 
(1)   Other comprehensive income was introduced under GAAP upon the adoption of Section 1530 on November 1, 2006 (refer to Note 1). Accordingly, there are no comparative figures for prior periods, other than the figures related to foreign currency translation gains (losses), which are now included as part of OCI.
 
n.a.   not applicable
Sources of future income taxes
                 
 
    2007     2006  
 
Future income tax asset
                
Allowance for credit losses
   $ 460     $ 439  
Deferred compensation
     642       616  
Pension related
     188       101  
Business realignment charges
     10       27  
Tax loss carryforwards
     91       68  
Deferred income
     115       151  
Enron litigation provision
     204       253  
Other (1)
     460       335  
 
 
     2,170       1,990  
 
Valuation allowance
     (10 )     (10 )
 
 
     2,160       1,980  
 
Future income tax liability
                
Premises and equipment
     (245 )     (214 )
Deferred expense
     (138 )     (225 )
Other (1)
     (526 )     (437 )
 
 
     (909 )     (876 )
 
Net future income tax asset
   $ 1,251     $ 1,104  
 
(1)   Includes deferred taxes from the transition adjustment and other comprehensive income as a result of the adoption of the new financial instruments accounting standards on November 1, 2006.
Royal Bank of Canada: Annual Report 2007
154  Consolidated Financial Statements

 

 

     Net future income tax assets are included in Other assets (refer to Note 12) and result from temporary differences between the tax basis of assets and liabilities and their carrying amounts on our Consolidated Balance Sheets. Included in the tax loss carryforwards amount is $91 million of future income tax assets related to losses in our Canadian, U.K. and U.S. operations (2006 — $31 million) which expire starting in 2008. There is no tax asset related to capital losses in 2007 (2006 — $27 million).
     We believe that, based on all available evidence, it is more likely than not that all of the future income tax assets, net of the valuation allowance, will be realized through a combination of future reversals of temporary differences and taxable income.
Reconciliation to statutory tax rate
                                                 
 
    2007     2006     2005  
 
Income taxes at Canadian statutory tax rate
   $ 2,431       34.6 %   $ 2,152       34.7 %   $ 1,632       34.7 %
(Decrease) increase in income taxes resulting from
Lower average tax rate applicable to subsidiaries
    (734 )     (10.4 )     (599 )     (9.6 )     (251 )     (5.3 )
Tax-exempt income from securities
    (272 )     (3.9 )     (184 )     (3.0 )     (85 )     (1.8 )
Tax rate change
    30       .4       13       .2       —       —  
Other
     (63 )     (.9 )     21       .3       (18 )     (.4 )
 
Income taxes reported in Consolidated Statements of Income before discontinued operations and effective tax rate
   $ 1,392       19.8 %   $ 1,403       22.6 %   $ 1,278       27.2 %
 
International earnings of certain subsidiaries would be taxed only upon their repatriation to Canada. We have not recognized a future income tax liability for these undistributed earnings as we do not currently expect them to be repatriated. Taxes that would be payable if all foreign subsidiaries’ accumulated unremitted earnings were repatriated are estimated at $843 million as at October 31,2007 (2006 — $822 million; 2005 — $745 million).
 
NOTE 25 EARNINGS PER SHARE
                         
 
    2007     2006     2005  
 
Basic earnings per share
                        
Net income from continuing operations
   $ 5,492     $ 4,757     $ 3,437  
Net loss from discontinued operations (1)
     —       (29 )     (50 )
 
Net income
     5,492       4,728       3,387  
 
Preferred share dividends
     (88 )     (60 )     (42 )
Net gain on redemption of preferred shares
     —       —       4  
 
Net income available to common shareholders
   $ 5,404     $ 4,668     $ 3,349  
 
Average number of common shares (in thousands)
     1,273,185       1,279,956       1,283,433  
Basic earnings (loss) per share
                        
Continuing operations
   $ 4.24     $ 3.67     $ 2.65  
Discontinued operations
     —       (.02 )     (.04 )
 
Total
   $ 4.24     $ 3.65     $ 2.61  
 
 
Diluted earnings per share
                        
Net income available to common shareholders
   $ 5,404     $ 4,668     $ 3,349  
 
Average number of common shares (in thousands)
     1,273,185       1,279,956       1,283,433  
Stock options (2)
     13,254       14,573       13,686  
Issuable under other stock-based compensation plans
     2,875       5,256       7,561  
 
Average number of diluted common shares (in thousands)
     1,289,314       1,299,785       1,304,680  
 
Diluted earnings (loss) per share
                        
Continuing operations
   $ 4.19     $ 3.61     $ 2.61  
Discontinued operations
     —       (.02 )     (.04 )
 
Total
   $ 4.19     $ 3.59     $ 2.57  
 
(1)   Refer to Note 11.
 
(2)   The dilutive effect of stock options was calculated using the treasury stock method. For 2007, we excluded from the calculation of diluted earnings per share 16,224 average options outstanding with an exercise price of $57.90 as the exercise price of these options was greater than the average market price of our common shares. During 2006 and 2005, no option was outstanding with an exercise price exceeding the average market price of our common shares.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  155

 

 

NOTE 26 CONCENTRATIONS OF CREDIT RISK
Concentrations of credit risk exist if a number of clients are engaged in similar activities, or are located in the same geographic region or have comparable economic characteristics such that their ability to meet contractual obligations would be similarly affected by changes in economic, political or other conditions. Concentrations of credit risk indicate the relative sensitivity of our performance to developments affecting a particular industry or geographic location. The amounts of credit exposure associated with our on- and off-balance sheet financial instruments are summarized in the following table:
                                                                                                                                                 
 
    2007   2006  
 
                                                    Other                                                                     Other              
                    United                             Inter-                                     United                             Inter-              
    Canada     %     States     %     Europe     %     national     %     Total     Canada     %     States     %     Europe     %     national     %     Total  
 
On-balance sheet assets other than derivatives (1)
   $ 227,206       72 %   $ 41,518       13 %     40,658       13 %   $ 6,146       2 %   $ 315,528     $ 204,488       73 %   $ 41,467       15 %   $ 27,358       10 %   $ 5,112       2 %   $ 278,425  
Derivatives before master netting agreement (2), (3)
     14,690       23       15,096       23       29,501       45       5,763       9       65,050       9,855       27       9,171       25       15,891       42       2,148       6       37,065  
 
 
   $ 241,896       64 %   $ 56,614       15 %   $ 70,159       18 %   $ 11,909       3 %   $ 380,578     $ 214,343       68 %   $ 50,368       16 %   $ 43,249       14 %   $ 7,260       2 %   $ 315,490  
 
Off-balance sheet credit instruments (4)
                                                                                                                                                
Committed and uncommitted (5)
   $ 81,251       55 %   $ 52,393       35 %   $ 12,725       9 %   $ 2,329       1 %   $ 148,698     $ 78,851       55 %   $ 51,224       35 %   $ 12,997       9 %   $ 1,802       1 %   $ 144,874  
Other
     31,194       53       13,418       23       14,226       24       87       —       58,925       28,563       47       11,563       19       19,776       33       738       1       60,640  
 
 
   $ 112,445       54 %   $ 65,811       32 %   $ 26,951       13 %   $ 2,416       1 %   $ 207,623     $ 107,414       52 %   $ 62,787       31 %   $ 32,773       16 %   $ 2,540       1 %   $ 205,514  
 
     
(1)   Includes assets purchased under reverse repurchase agreements and securities borrowed, loans and customers’ liability under acceptances. The largest concentrations in Canada are Ontario at 51% (2006—52%), the Prairies at 16% (2006—14%), British Columbia at 15% (2006—14%) and Quebec at 14% (2006—15%). No industry accounts for more than 10% of total on-balance sheet credit instruments.
 
(2)   The largest concentration of credit exposure by counterparty type is banks at 60% (2006 — 59%).
 
(3)   Excludes credit derivatives classified as other than trading with a replacement cost of $36 million (2006 — $20 million).
 
(4)   Represents financial instruments with contractual amounts representing credit risk.
 
(5)   Of the commitments to extend credit, the largest industry concentration relates to financial services of 40% (2006 — 38%), mining and energy of 12% (2006 — 13%), commercial real estate of 7% (2006 — 6%), government of 4% (2006 — 5%), wholesale of 4% (2006 — 5%), manufacturing of 4% (2006 — 4%) and transportation of 3% (2006 — 3%).
NOTE 27 GUARANTEES, COMMITMENTS AND CONTINGENCIES
Guarantees
In the normal course of our business, we enter into numerous agreements that may contain features that meet the definition of a guarantee pursuant to AcG-14. AcG-14 defines a guarantee to be a contract (including an indemnity) that contingently requires us to make payments (in cash, other assets, our own shares or provision of services) to a third party based on: (i) changes in an underlying interest rate, foreign exchange rate, equity or commodity instrument, index or other variable, that is related to an asset, a liability or an equity security of the counterparty; (ii) failure of another party to perform under an obligating agreement; or (iii) failure of another third party to pay its indebtedness when due. Effective November 1, 2006, a liability is now recognized on our Consolidated Balance Sheets at the inception of a guarantee for the fair value of the obligation undertaken in issuing the guarantee. No subsequent remeasurement at fair value is required unless the financial guarantee qualifies as a derivative. If the financial guarantee meets the definition of a derivative, it is remeasured at fair value at each balance sheet date and reported as a derivative in Other assets or Other liabilities as appropriate.
     As the carrying value of these financial guarantees is not indicative of the maximum potential amount of future payments, we continue to consider financial guarantees as off-balance sheet credit instruments. The maximum potential amount of future payments represents the maximum risk of loss if there was a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions, insurance policies or from collateral held or pledged.
     The table below summarizes significant guarantees we have provided to third parties:
                                 
             
    2007     2006  
    Maximum             Maximum        
    potential amount             potential amount        
    of future     Carrying     of future     Carrying  
    payments     amount     payments     amount (1)  
 
Credit derivatives and written put options (2), (3)
   $ 70,242     $ 2,657     $ 54,723     $ 352  
Backstop liquidity facilities
     43,066       41       34,342       —  
Stable value products (3)
     17,369       —       16,098       —  
Financial standby letters of credit and performance guarantees (4)
     16,661       57       15,902       17  
Credit enhancements
     4,814       30       4,155       —  
Mortgage loans sold with recourse
     230       —       204       —  
 
(1)   For credit derivatives and written put options, the prior period comparatives represent the fair values of the derivatives; for financial standby letters of credit and performance guarantees, they represent unamortized premiums received.
 
(2)   The carrying amount is included in Other — Derivatives on our Consolidated Balance Sheets.
 
(3)   The notional amount of these contracts approximates the maximum potential amount of future payments.
 
(4)   The carrying amount is included in Other—Other liabilities on our Consolidated Balance Sheets.
Royal Bank of Canada: Annual Report 2007
156  Consolidated Financial Statements

 

 

     In addition to the above guarantees, we transact substantially all of our securities lending activities in which we act as an agent for the owners of securities through our joint venture, RBC Dexia IS. As at October 31, 2007, RBC Dexia IS securities lending indemnifications totalled $63,462 million (2006 — $45,614 million); we are exposed to 50% of this amount.
Credit derivatives and written put options
Our clients may enter into credit derivatives or written put options for speculative or hedging purposes. AcG-14 defines a guarantee to include derivative contracts that contingently require us to make payments to a guaranteed party based on changes in an underlying that is related to an asset, a liability or an equity security of a guaranteed party. We have only disclosed amounts for transactions where it would be probable, based on the information available to us, that the client would use the credit derivative or written put option to protect against changes in an underlying that is related to an asset, a liability or an equity security held by the client.
     We enter into written credit derivatives that are over-the-counter contractual agreements to compensate another party for its financial loss following the occurrence of a credit event in relation to a specified reference obligation, such as a bond or loan. The terms of these credit derivatives vary based on the contract and can range up to 15 years.
     We enter into written put options that are contractual agreements under which we grant the purchaser the right, but not the obligation to sell, by or at a set date, a specified amount of a financial instrument at a predetermined price. Written put options that typically qualify as guarantees include foreign exchange contracts, equity-based contracts and certain commodity-based contracts. The term of these options varies based on the contract and can range up to five years.
     Collateral we hold for credit derivatives and written put options is managed on a portfolio basis and may include cash, government T-bills and bonds.
Backstop liquidity facilities
Backstop liquidity facilities are provided to asset-backed commercial paper conduit programs (programs) administered by us and third parties, as an alternative source of financing in the event that such programs are unable to access commercial paper markets, or in limited circumstances, when predetermined performance measures of the financial assets owned by these programs are not met. We generally provide liquidity facilities for a term of one year.
     Backstop liquidity facilities are also provided to non-asset-backed programs such as variable rate demand notes issued by third parties. These standby facilities provide liquidity support to the issuer to buy the notes if the issuer is unable to remarket the notes, as long as the instrument and/or the issuer maintains the investment grade rating.
     The terms of the backstop liquidity facilities do not require us to advance money to these programs in the event of bankruptcy or to purchase non-performing or defaulted assets. None of the backstop liquidity facilities that we have provided have been drawn upon.
Stable value products
We sell stable value products that offer book value protection primarily to plan sponsors of Employee Retirement Income Security Act of 1974 (ERISA)-governed pension plans such as 401(k) plans and 457 plans. The book value protection is provided on portfolios of intermediate/short-term investment-grade fixed income securities and is intended to cover any shortfall in the event that plan participants withdraw funds when market value is below book value. We retain the option to exit the contract at any time. For stable value products, collateral we hold is managed on a portfolio basis and may include cash, government T-bills and bonds.
Financial standby letters of credit and performance guarantees
Financial standby letters of credit and performance guarantees represent irrevocable assurances that we will make payments in the event that a client cannot meet its obligations to third parties. The term of these guarantees can range up to eight years. Our policy for requiring collateral security with respect to these instruments and the types of collateral security held is generally the same as for loans. When collateral security is taken, it is determined on an account by account basis according to the risk of the borrower and the specifics of the transaction. Collateral security may include cash, securities and other assets pledged.
Credit enhancements
We provide partial credit enhancement to multi-seller programs administered by us to protect commercial paper investors in the event that the collection on the underlying assets, the transaction specific credit enhancement or the liquidity proves to be insufficient to pay for maturing commercial paper. Each of the asset pools is structured to achieve a high investment-grade credit profile through credit enhancement related to each transaction. The term of these credit facilities is between one and four years.
Mortgage loans sold with recourse
Through our various agreements with investors, we may be required to repurchase U.S. originated mortgage loans sold to an investor if the loans are uninsured for greater than one year, or refund any premium received where mortgage loans are prepaid or in default within 120 days. The mortgage loans are fully collateralized by residential properties.
Securities lending indemnifications
We generally transact securities lending transactions through our joint venture, RBC Dexia IS. In these transactions, RBC Dexia IS acts as an agent for the owner of a security, who agrees to lend the security to a borrower for a fee, under the terms of a pre-arranged contract. The borrower must fully collateralize the security loaned at all times. As part of this custodial business, an indemnification may be provided to securities lending customers to ensure that the fair value of securities loaned will be returned in the event that the borrower fails to return the borrowed securities and the collateral held is insufficient to cover the fair value of those securities. These indemnifications normally terminate without being drawn upon. The term of these indemnifications varies, as the securities loaned are recallable on demand. Collateral held for our securities lending transactions typically includes cash or securities that are issued or guaranteed by the Canadian government, U.S. government or other OECD countries.
Indemnifications
In the normal course of our operations, we provide indemnifications which are often standard contractual terms to counterparties in transactions such as purchase and sale contracts, service agreements, director/officer contracts and leasing transactions. These indemnification agreements may require us to compensate the counterparties for costs incurred as a result of changes in laws and regulations (including tax legislation) or as a result of litigation claims or statutory sanctions that may be suffered by the counterparty as a consequence of the transaction. The terms of these indemnification agreements will vary based on the contract. The nature of the indemnification agreements prevents us from making a reasonable estimate of the maximum potential amount we could be required to pay to counterparties. Historically, we have not made any significant payments under such indemnifications.
Other off-balance sheet credit instruments
In addition to financial guarantees, we utilize other off-balance sheet credit instruments to meet the financing needs of our clients. The contractual amounts of these credit instruments represent the maximum possible credit risk without taking into account the fair value of any collateral, in the event other parties fail to perform their obligations under these instruments. Our credit review process, our policy for requiring collateral security and the types of collateral security held
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  157

 

 

NOTE 27 GUARANTEES, COMMITMENTS AND CONTINGENCIES (continued)
are generally the same as for loans. Many of these instruments expire without being drawn upon. As a result, the contractual amounts may not necessarily represent our actual future credit risk exposure or cash flow requirements.
     Commitments to extend credit represent unused portions of authorizations to extend credit in the form of loans, bankers’ acceptances or letters of credit.
     In securities lending transactions, we lend our own or our clients’ securities to a borrower for a fee under the terms of a pre-arranged contract. The borrower must fully collateralize the security loaned at all times.
     Uncommitted amounts represent an amount for which we retain the option to extend credit to a borrower.
     Documentary and commercial letters of credit, which are written undertakings by us on behalf of a client authorizing a third party to draw drafts on us up to a stipulated amount under specific terms and conditions, are collateralized by the underlying shipment of goods to which they relate.
     A note issuance facility represents an underwriting agreement that enables a borrower to issue short-term debt securities. A revolving underwriting facility represents a renewable note issuance facility that can be accessed for a specified period of time.
The following table summarizes the contractual amounts of our other off-balance sheet credit instruments:
Other off-balance sheet credit instruments
                 
   
    2007     2006  
 
Commitments to extend credit (1)
                
Original term to maturity of 1 year or less
   $ 55,281     $ 57,154  
Original term to maturity of more than 1 year
     46,307       42,222  
Securities lending
     36,187       38,185  
Uncommitted amounts (2)
     47,110       45,498  
Documentary and commercial letters of credit
     501       713  
Note issuances and revolving underwriting facilities
     —       8  
 
 
   $ 185,386     $ 183,780  
 
 
(1)   Includes liquidity facilities.
 
(2)   Includes uncommitted liquidity loan facilities of $42.2 billion (2006 — $34.6 billion) provided to RBC-administered multi-seller conduits. As at October 31, 2007, $758 million (2006 — $ nil) was drawn upon on these facilities and is included in Loans.
Pledged assets
In the ordinary course of business, we pledge assets recorded on our Consolidated Balance Sheets. Details of assets pledged against liabilities are shown in the following tables:
Pledged assets
                 
   
    2007     2006  
 
Cash and due from banks
   $ 305     $ 100  
Interest-bearing deposits with banks
     3,443       1,936  
Loans
     1,733       187  
Securities
     51,695       56,580  
Assets purchased under reverse repurchase agreements
     40,698       36,788  
Other assets
     1,132       941  
 
 
   $ 99,006     $ 96,532  
 
                 
   
    2007     2006  
 
Assets pledged to:
                
Foreign governments and central banks
   $ 1,981     $ 1,794  
Clearing systems, payment systems and depositories
     1,772       2,309  
Assets pledged in relation to:
                
Securities borrowing and lending
     34,881       38,118  
Obligations related to securities sold under repurchase agreements
     48,479       44,651  
Derivative transactions
     8,502       6,547  
Other
     3,391       3,113  
 
 
   $ 99,006     $ 96,532  
 
Royal Bank of Canada: Annual Report 2007
158  Consolidated Financial Statements

 

 

Collateral
As at October 31, 2007, the approximate market value of collateral accepted that may be sold or repledged by us was $122.4 billion (2006 — $109.1 billion). This collateral was received in connection with reverse repurchase agreements, securities borrowings and loans, and derivative transactions. Of this amount, $56.5 billion (2006 — $48.0 billion) has been sold or repledged, generally as collateral under repurchase agreements or to cover short sales.
Lease commitments
Minimum future rental commitments for premises and equipment under long-term non-cancellable operating and capital leases for the next five years and thereafter are as follows:
         
Lease commitments(1)        
 
        
 
2008
   $ 494  
2009
     453  
2010
     382  
2011
     329  
2012
     279  
Thereafter
     1,224  
 
 
   $ 3,161  
 
(1)   Substantially all of our lease commitments are related to operating leases.
Litigation
Enron Corp. (Enron) litigation
A purported class of purchasers of Enron who publicly traded equity and debt securities between January 9, 1999, and November 27, 2001, has named Royal Bank of Canada and certain related entities as defendants in an action entitled Regents of the University of California v. Royal Bank of Canada in the United States District Court, Southern District of Texas (Houston Division). In addition, Royal Bank of Canada and certain related entities have been named as defendants in several other Enron-related cases, which are filed in various courts in the U.S., asserting similar claims filed by purchasers of Enron securities. Royal Bank of Canada is also a third-party defendant in cases in which Enron’s accountants, Arthur Andersen LLP, filed third-party claims against a number of parties, seeking contribution if Arthur Andersen LLP is found liable to plaintiffs in these actions.
     We review the status of these matters on an ongoing basis and will exercise our judgment in resolving them in such a manner as we believe to be in our best interests. As with any litigation, there are significant uncertainties surrounding the timing and outcome. Uncertainty is exacerbated as a result of the large number of cases, the multiple defendants in many of them, the novel issues presented, and the current difficult litigation environment. Although it is not possible to predict the ultimate outcome of these lawsuits, the timing of their resolution or our exposure, during the fourth quarter of 2005, we established a litigation provision of $591 million (US$500 million) or $326 million after-tax (US$276 million). We believe the ultimate resolution of these lawsuits and other proceedings, while not likely to have a material adverse effect on our consolidated financial position, may be material to our operating results for the particular period in which the resolution occurs, notwithstanding the provision established in the fourth quarter of 2005. We will continue to vigorously defend ourselves in these cases.
Other
Various other legal proceedings are pending that challenge certain of our practices or actions. We consider that the aggregate liability resulting from these other proceedings will not be material to our financial position or results of operations.
NOTE 28 CONTRACTUAL REPRICING AND MATURITY SCHEDULE
The following table details our exposure to interest rate risk as defined and prescribed by CICA Handbook Section 3861, Financial Instruments - Disclosure and Presentation. On- and off-balance sheet financial instruments are reported based on the earlier of their contractual repricing date or maturity date. Effective interest rates have been disclosed where applicable. The effective rates shown represent historical rates for fixed-rate instruments carried at amortized cost and current market rates for floating-rate instruments or instruments carried at fair value. The following table does not incorporate management’s expectation of future events where expected repricing or maturity dates differ significantly from the contractual dates. We incorporate these assumptions in the management of interest rate risk exposure. These assumptions include expected repricing of trading instruments and certain loans and deposits. Taking into account these assumptions on the consolidated contractual repricing and maturity schedule at October 31, 2007, would result in a change in the under-one-year gap from $(74.4) billion to $(53.3) billion (2006 — $(79.8) billion to $(40.2) billion).
     
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  159

 

 

NOTE 28 CONTRACTUAL REPRICING AND MATURITY SCHEDULE (continued)
Carrying amount by earlier of contractual repricing or maturity date
                                                                 
 
    Immediately                                            
    interest     Under 3     3 to 6     Over 6 to     Over 1 to     Over 5     Non-rate-        
    rate-sensitive     months     months     12 months     5 years     years     sensitive     Total  
 
Assets
                                                                
Cash and deposits with banks
   $ —     $ 14,317     $ —     $ —     $ —     $ —     $ 1,790     $ 16,107  
Effective interest rate
     —       4.71 %     —       —       —       —       —          
Securities
                                                                
Trading
     —       27,559       4,856       5,208       22,790       26,149       61,684       148,246  
Effective interest rate
     —       4.66 %     4.74 %     4.63 %     4.71 %     4.97 %     —          
Available-for-sale
     —       8,263       1,958       2,096       12,240       2,326       3,126       30,009  
Effective interest rate
     —       4.68 %     4.84 %     4.77 %     4.78 %     4.92 %     —          
Assets purchased under reverse repurchase agreements and securities borrowed
     —       62,393       1,920       —       —       —       —       64,313  
Effective interest rate
     —       4.81 %     4.67 %     —       —       —       —          
Loans (net of allowance for loan losses) (1)
     101,692       25,664       8,079       14,071       80,795       7,418       217       237,936  
Effective interest rate
     —       5.46 %     5.54 %     5.31 %     5.38 %     6.04 %     —          
Derivatives
     28,591       2,480       —       —       6       —       35,508       66,585  
Effective interest rate
     —       4.79 %     —       —       4.62 %     —       —          
Other assets
     —       —       —       —       —       —       37,150       37,150  
 
 
   $ 130,283     $ 140,676     $ 16,813     $ 21,375     $ 115,831     $ 35,893     $ 139,475     $ 600,346  
 
Liabilities
                                                                
Deposits
   $ 148,072     $ 112,388     $ 23,461     $ 24,779     $ 49,219     $ 5,915     $ 1,371     $ 365,205  
Effective interest rate
     —       4.45 %     4.42 %     4.36 %     4.18 %     4.81 %     —          
Obligations related to assets sold under repurchase agreements and securities loaned
     —       34,748       1,838       396       —       —       51       37,033  
Effective interest rate
     —       4.77 %     4.76 %     4.79 %     —       —       —          
Obligations related to securities sold short
     —       1,402       316       596       10,892       11,097       20,386       44,689  
Effective interest rate
     —       4.72 %     4.71 %     4.59 %     4.54 %     4.87 %     —          
Derivatives
     29,346       4,404       —       —       4       13       38,243       72,010  
Effective interest rate
     —       4.80 %     —       —       4.60 %     4.96 %     —          
Other liabilities
     —       250       106       273       649       214       46,060       47,552  
Effective interest rate
     —       4.82 %     4.85 %     4.64 %     4.65 %     5.10 %     —          
Subordinated debentures
     —       886       —       —       3,892       1,465       (8 )     6,235  
Effective interest rate
     —       5.64 %     —       —       5.01 %     6.40 %     —          
Trust capital securities
     —       —       —       —       1,400       —       —       1,400  
Effective interest rate
     —       —       —       —       7.23 %     —       —          
Preferred share liabilities
     —       —       —       300       —       —       —       300  
Effective interest rate
     —       —       —       4.72 %     —       —       —          
Non-controlling interest in subsidiaries
     —       —       —       —       1,200       —       283       1,483  
Effective interest rate
     —       —       —       —       4.87 %     —       —          
Shareholders’ equity
     —       —       —       —       —       2,050       22,389       24,439  
Effective interest rate
     —       —       —       —       —       4.14 %     —          
 
 
   $ 177,418     $ 154,078     $ 25,721     $ 26,344     $ 67,256     $ 20,754     $ 128,775     $ 600,346  
 
Total gap based on contractual repricing
   $ (47,135 )   $ (13,402 )   $ (8,908 )   $ (4,969 )   $ 48,575     $ 15,139     $ 10,700     $ —  
 
Canadian dollar
     (23,067 )     9,417       11,450       (6,183 )     22,680       (6,296 )     (8,000 )     1  
Foreign currency
     (24,068 )     (22,819 )     (20,358 )     1,214       25,895       21,435       18,700       (1 )
 
Total gap
   $ (47,135 )   $ (13,402 )   $ (8,908 )   $ (4,969 )   $ 48,575     $ 15,139     $ 10,700     $ —  
 
Canadian dollar — 2006
   $ (26,367 )   $ (24,559 )   $ 5,204     $ (1,764 )   $ 52,937     $ 11,628     $ (17,083 )   $ (4 )
Foreign currency — 2006
     (18,902 )     8,856       (19,898 )     (2,372 )     14,282       21,917       (3,879 )     4  
 
Total gap — 2006
   $ (45,269 )   $ (15,703 )   $ (14,694 )   $ (4,136 )   $ 67,219     $ 33,545     $ (20,962 )   $ —  
 
(1)   Includes loans totalling $1,202 million to a variable interest entity administered by us, with maturity terms exceeding five years.
NOTE 29 RELATED PARTY TRANSACTIONS
In the ordinary course of business, we provide normal banking services and operational services, and enter into other transactions with associated and other related corporations, including our joint venture entities, on terms similar to those offered to non-related parties. Refer to Note 9 for more information regarding our joint venture, RBC Dexia IS.
     We grant loans to directors, officers and other employees at rates normally accorded to preferred clients. As at October 31, 2007, the aggregate indebtedness, excluding routine indebtedness, to RBC or its subsidiaries of current directors and executive officers was approximately $3.2 million. Routine indebtedness includes (i) loans made on terms no more favourable than loans to employees generally, but not exceeding $50,000 to any directors and executive officer; (ii) loans to employees, fully secured against their residence and not exceeding their annual salary; (iii) loans, other than to employees, on substantially the same terms available to other customers with comparable credit ratings and involving no more than the usual risk of collectibility; and (iv) loans for purchases on usual trade terms, or for ordinary travel or expense advances, with usual commercial repayment arrangements. We also offer deferred share and other plans to non-employee directors, executives and certain other key employees. Refer to Note 21.
     
Royal Bank of Canada: Annual Report 2007
160  Consolidated Financial Statements

 

 

NOTE 30 RESULTS BY BUSINESS AND GEOGRAPHIC SEGMENT
                                                                         
 
                    U.S. &                                            
    Canadian     Wealth     International     Capital     Corporate                             Other  
2007   Banking     Management     Banking     Markets (1)     Support (1)     Total     Canada     United States     International  
 
Net interest income
   $ 6,353     $ 427     $ 1,031     $ 453     $ (732 )   $ 7,532     $ 6,435     $ 412     $ 685  
Non-interest income
     6,168       3,565       884       3,936       377       14,930       8,605       4,322       2,003  
 
Total revenue
     12,521       3,992       1,915       4,389       (355 )     22,462       15,040       4,734       2,688  
Provision for (recovery of) credit losses
     788       1       109       (22 )     (85 )     791       696       90       5  
Insurance policyholder benefits, claims and acquisition expense
     2,173       —       —       —       —       2,173       1,230       474       469  
Non-interest expense
     5,285       2,902       1,481       2,769       36       12,473       7,409       3,405       1,659  
 
Net income (loss) before income taxes
     4,275       1,089       325       1,642       (306 )     7,025       5,705       765       555  
Income taxes
     1,288       327       74       278       (575 )     1,392       1,705       (62 )     (251 )
Non-controlling interest
     —       —       9       72       60       141       83       49       9  
 
Net income
   $ 2,987     $ 762     $ 242     $ 1,292     $ 209     $ 5,492     $ 3,917     $ 778     $ 797  
Less: Preferred dividends
     34       9       14       20       11       88       56       24       8  
 
Net income (loss) available to common shareholders
   $ 2,953     $ 753     $ 228     $ 1,272     $ 198     $ 5,404     $ 3,861     $ 754     $ 789  
 
Average assets (2)
   $ 220,000     $ 16,600     $ 39,700     $ 311,200     $ (6,500 )   $ 581,000     $ 317,900     $ 135,100     $ 128,000  
 
Total average assets
   $ 220,000     $ 16,600     $ 39,700     $ 311,200     $ (6,500 )   $ 581,000     $ 317,900     $ 135,100     $ 128,000  
 
                                                                         
 
                    U.S. &                                            
    Canadian     Wealth     International     Capital     Corporate                             Other  
2006   Banking     Management     Banking     Markets (1)     Support (1)     Total     Canada     United States     International  
 
Net interest income
   $ 5,816     $ 397     $ 940     $ 131     $ (488 )   $ 6,796     $ 6,045     $ 108     $ 643  
Non-interest income
     5,880       3,090       688       4,005       178       13,841       7,518       4,397       1.926  
 
Total revenue
     11,696       3,487       1,628       4,136       (310 )     20,637       13,563       4,505       2,569  
Provision for (recovery of) credit losses
     604       1       25       (115 )     (86 )     429       456       (28 )     1  
Insurance policyholder benefits, claims and acquisition expense
     2,509       —       —       —       —       2,509       1,379       683       447  
Non-interest expense
     5,027       2,613       1,216       2,603       36       11,495       7,056       3,038       1,401  
Business realignment charges
     —       1       —       (1 )     —       —       —       —       —  
 
Net income (loss) before income taxes
     3,556       872       387       1,649       (260 )     6,204       4,672       812       720  
Income taxes
     1,130       268       117       317       (429 )     1,403       1,458       14       (69 )
Non-controlling interest
     —       —       9       (23 )     58       44       37       (1 )     8  
 
Net income (loss) from continuing operations
   $ 2,426     $ 604     $ 261     $ 1,355     $ 111     $ 4,757     $ 3,177     $ 799     $ 781  
Net loss from discontinued operations
     —       —       (29 )     —       —       (29 )     —       (29 )     —  
 
Net income
     2,426       604       232       1,355       111       4,728       3,177       770       781  
Less: Preferred dividends
     24       6       7       13       10       60       40       15       5  
 
Net income (loss) available to common shareholders
   $ 2,402     $ 598     $ 225     $ 1,342     $ 101     $ 4,668     $ 3,137     $ 755     $ 776  
 
Average assets from continuing operations (2)
   $ 199,200     $ 15,100     $ 32,600     $ 260,600     $ (5,400 )   $ 502,100     $ 287,200     $ 113,300     $ 101,600  
Average assets from discontinued operations (2)
     —       —       200       —       —       200       —       200       —  
 
Total average assets
   $ 199,200     $ 15,100     $ 32,800     $ 260,600     $ (5,400 )   $ 502,300     $ 287,200     $ 113,500     $ 101,600  
 
                                                                         
 
                    U.S. &                                            
    Canadian     Wealth     International     Capital     Corporate                             Other  
2005   Banking     Management     Banking     Markets (1)     Support (1)     Total     Canada     United States     International  
 
Net interest income
   $ 5,233     $ 374     $ 923     $ 557     $ (294 )   $ 6,793     $ 5,628     $ 608     $ 557  
Non-interest income
     5,765       2,777       654       3,005       190       12,391       6,878       3,955       1,558  
 
Total revenue
     10,998       3,151       1,577       3,562       (104 )     19,184       12,506       4,563       2,115  
Provision for (recovery of) credit losses
     542       2       49       (91 )     (47 )     455       433       23       (1 )
Insurance policyholder benefits, claims and acquisition expense
     2,625       —       —       —       —       2,625       1,270       809       546  
Non-interest expense
     4,830       2,440       1,136       2,890       61       11,357       6,685       3,595       1,077  
Business realignment charges
     7       1       (3 )     1       39       45       45       —       —  
 
Net income (loss) before income taxes
     2,994       708       395       762       (157 )     4,702       4,073       136       493  
Income taxes
     987       206       133       95       (143 )     1,278       1,329       (76 )     25  
Non-controlling interest
     —       —       6       (19 )     —       (13 )     (30 )     12       5  
 
Net income (loss) from continuing operations
     2,007       502       256       686       (14 )     3,437       2,774       200       463  
Net loss from discontinued operations
     —       —       (50 )     —       —       (50 )     —       (50 )     —  
 
Net income (loss)
   $ 2,007     $ 502     $ 206     $ 686     $ (14 )   $ 3,387     $ 2,774     $ 150     $ 463  
Less: Preferred dividends
     15       4       5       8       6       38       25       10       3  
 
Net income (loss) available to common shareholders
   $ 1,992     $ 498     $ 201     $ 678     $ (20 )   $ 3,349     $ 2,749     $ 140     $ 460  
 
Average assets from continuing operations (2)
   $ 181,100     $ 13,200     $ 25,900     $ 229,100     $ (4,000 )   $ 445,300     $ 263,200     $ 92,400     $ 89,700  
Average assets from discontinued operations (2)
     —       —       1,800       —       —       1,800       —       1,800       —  
 
Total average assets
   $ 181,100     $ 13,200     $ 27,700     $ 229,100     $ (4,000 )   $ 447,100     $ 263,200     $ 94,200     $ 89,700  
 
(1)   Taxable equivalent basis.
 
(2)   Calculated using methods intended to approximate the average of the daily balances for the period.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  161

 

 

NOTE 30 RESULTS BY BUSINESS AND GEOGRAPHIC SEGMENT (continued)
Revenue by business line
                         
 
    2007     2006     2005  
 
Banking (1)
   $ 10,485     $ 9,418     $ 8,761  
Wealth management
     3,992       3,487       3,151  
Global insurance
     3,192       3,348       3,311  
Global markets (2)
     2,455       2,579       2,256  
Global investment banking and equity markets (2), (3)
     1,675       1,382       1,098  
RBC Dexia IS (4)
     759       558       500  
Other (5)
     (96 )     (135 )     104  
 
Total
   $ 22,462     $ 20,637     $ 19,184  
 
(1)   Includes cards and payment solutions.
 
(2)   Taxable equivalent basis.
 
(3)   Includes our National Clients business, which was transferred from our Other line of business in the second quarter of 2007.
 
(4)   The amount for 2006 includes two months of revenue from IIS and our 50% proportionate share of nine months of revenue from RBC Dexia IS for the year ended October 31, 2006. Comparative amounts for 2005 only represent revenue from IIS.
 
(5)   Consists of Global Credit and Research business, and includes the tax equivalent basis adjustment which is discussed below.
Changes in 2007
Composition of business segments
Effective February 7, 2007, our previous three business segments (RBC Canadian Personal and Business, RBC U.S. and International Personal and Business, and RBC Capital Markets) were reorganized into the following four business segments:
     Canadian Banking comprises our domestic, personal and business banking operations, certain retail investment businesses and our global insurance operations.
     Wealth Management comprises businesses that directly serve the growing wealth management needs of affluent and high net worth clients in Canada, the U.S. and North America, and businesses that provide asset management and trust products through RBC and external partners.
     U.S. & International Banking comprises our banking businesses outside Canada, including our banking operations in the U.S. and the Caribbean. In addition, this segment includes our 50% ownership in RBC Dexia IS.
     Capital Markets comprises our global wholesale banking business segment, which provides a wide range of corporate and investment banking, sales and trading, research and related products and services to corporate, public sector and institutional clients in North America, and specialized products and services in select global markets.
     The comparative results have been revised to conform to our new basis of segment presentation.
     All other enterprise level activities that are not allocated to these four business segments, such as enterprise funding securitization, net funding associated with unattributed capital, and consolidation adjustments, including the elimination of the taxable equivalent basis (teb) gross-up amounts, are included in Corporate Support. Teb adjustments gross up Net interest income from certain tax-advantaged sources (Canadian taxable corporate dividends) to their effective tax equivalent value with the corresponding offset recorded in the provision for income taxes. Management believes that these adjustments are necessary for Capital Markets to reflect how it is managed. The use of the teb adjustments enhances the comparability of revenue across our taxable and tax-advantaged sources. The use of teb adjustments and measures may not be comparable to similar GAAP measures or similarly adjusted amounts at other financial institutions. The teb adjustment for 2007 was $332 million (2006 — $213 million, 2005 — $109 million).
     During 2007, we also reclassified the following balances in reporting our business segments: (i) certain amounts reported in Capital Markets from Interest income to Interest expense with no impact on Net interest income; (ii) certain amounts related to interest settlements on swaps in fair value hedge relationships from Non-interest income to Net interest income which had no impact on the prior years’ results; (iii) certain deposits in Capital Markets and U.S. & International Banking related to RBC Dexia IS in accordance with the business realignment that occurred in the second quarter 2007; (iv) expenses related to internally developed software from Non-interest expense — Other to the more specific Non-interest expense lines. Only Corporate Support was impacted by this reclassification and there was no impact on total Non-interest expense; and (v) certain amounts related to trustee services within Canadian Banking have been reclassified from Non-interest income — Investment management and custodial fees to Net interest income to reflect their nature. All comparative amounts have been revised to reflect these reclassifications.
Visa Restructuring
In connection with the restructuring of Visa Inc., which was completed on October 3, 2007, RBC’s membership interest in Visa Canada Association was exchanged for shares of Visa Inc., resulting in a gain of $326 million ($269 million net of taxes). The gain, which is based on an independent valuation of RBC’s shares in Visa Inc., is included in Canadian Banking’s Total revenue and recorded in Non-interest income - Other in our Consolidated Statement of Income. The shares of Visa Inc. are classified as Available-for-sale securities. Refer to Note 3.
Management reporting framework
Our management reporting framework is intended to measure the performance of each business segment as if it was a stand-alone business and reflect the way that business segment is managed. This approach ensures our business segments’ results reflect all relevant revenue and expenses associated with the conduct of their business and depicts how management views those results. These items do not impact our consolidated results.
     The expenses in each business segment may include costs or services directly incurred or provided on their behalf at the enterprise level. For other costs not directly attributable to one of our business segments, we use a management reporting framework that uses assumptions, estimates and methodologies for allocating overhead costs and indirect expenses to our business segments and that assists in the attribution of capital and the transfer pricing of funds to our business segments in a manner that fairly and consistently measures and aligns the economic costs with the underlying benefits and risks of that specific business segment. Activities and business conducted between our business segments are generally at market rates. All other enterprise level activities that are not allocated to our four business segments are reported under Corporate Support.
     Our assumptions and methodologies used in our management reporting framework are periodically reviewed by management to ensure they remain valid. The capital attribution methodologies involve a number of assumptions and estimates that are revised periodically.
Geographic segments
For geographic reporting, our segments are grouped into Canada, United States and Other International. Transactions are primarily recorded in the location that best reflects the risk due to negative changes in economic conditions, and prospects for growth due to positive economic changes. This location frequently corresponds with the location of the legal entity through which the business is conducted and the location of our clients. Transactions are recorded in the local currency and are subject to foreign exchange rate fluctuations with respect to the movement in the Canadian dollar.
Royal Bank of Canada: Annual Report 2007
162  Consolidated Financial Statements

 

 

NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES
Our Consolidated Financial Statements are prepared in accordance with Subsection 308 of the Bank Act (Canada), which states that except as otherwise specified by the OSFI, our Consolidated Financial Statements are to be prepared in accordance with Canadian GAAP. As required by the U.S. Securities and Exchange Commission (SEC), material differences between Canadian and U.S. GAAP are quantified and described below. We adopted SEC Staff Accounting Bulletin No. 108 on November 1, 2006. Refer to the discussion under the Significant accounting changes section later in this note.
Condensed Consolidated Balance Sheets
                                                 
 
    2007     2006  
    Canadian GAAP     Differences     U.S. GAAP     Canadian GAAP     Differences     U.S. GAAP  
 
Assets
                                                
Cash and due from banks
   $ 4,226     $ (78 )   $ 4,148     $ 4,401     $ (101 )   $ 4,300  
 
Interest-bearing deposits with banks
     11,881       (4,436 )     7,445       10,502       (4,223 )     6,279  
 
Securities
                                                
Trading
     148,246       (5,348 )     142,898       147,237       (282 )     146,955  
Available-for-sale
     30,009       6,326       36,335       —       —       —  
Investments
     —       —       —       37,632       (97 )     37,535  
 
 
     178,255       978       179,233       184,869       (379 )     184,490  
 
Assets purchased under reverse repurchase agreements and securities borrowed
     64,313       (2,263 )     62,050       59,378       (2,148 )     57,230  
 
Loans (net of allowance for loan losses)
     237,936       (2,188 )     235,748       208,530       (111 )     208,419  
 
Other
                                                
Customers’ liability under acceptances
     11,786       —       11,786       9,108       —       9,108  
Derivatives
     66,585       (295 )     66,290       37,729       717       38,446  
Premises and equipment, net
     2,131       (102 )     2,029       1,818       (86 )     1,732  
Goodwill
     4,752       (61 )     4,691       4,304       (61 )     4,243  
Other intangibles
     628       (180 )     448       642       (211 )     431  
Reinsurance recoverables
     —       1,140       1,140       —       1,182       1,182  
Separate account assets
     —       114       114       —       111       111  
Assets of operations held for sale
     —       —       —       82       —       82  
Other assets
     17,853       30,590       48,443       15,417       24,893       40,310  
 
 
     103,735       31,206       134,941       69,100       26,545       95,645  
 
 
   $ 600,346     $ 23,219     $ 623,565     $ 536,780     $ 19,583     $ 556,363  
 
Liabilities and shareholders’ equity
                                               
Deposits
   $ 365,205     $ (12,276 )   $ 352,929     $ 343,523     $ (9,466 )   $ 334,057  
 
Other
                                                
Acceptances
     11,786       —       11,786       9,108       —       9,108  
Obligations related to securities sold short
     44,689       829       45,518       38,252       (1,188 )     37,064  
Obligations related to assets sold under repurchase agreements and securities loaned
     37,033       (1,290 )     35,743       41,103       (1,141 )     39,962  
Derivatives
     72,010       (312 )     71,698       42,094       312       42,406  
Insurance claims and policy benefit liabilities
     7,283       2,530       9,813       7,337       2,686       10,023  
Separate account liabilities
     —       114       114       —       111       111  
Liabilities of operations held for sale
     —       —       —       32       —       32  
Other liabilities
     28,483       33,712       62,195       22,649       27,877       50,526  
 
 
     201,284       35,583       236,867       160,575       28,657       189,232  
 
Subordinated debentures
     6,235       6       6,241       7,103       300       7,403  
Trust capital securities
     1,400       (1,400 )     —       1,383       (1,383 )     —  
Preferred share liabilities
     300       (300 )     —       298       (298 )     —  
Non-controlling interest in subsidiaries
     1,483       1,405       2,888       1,775       1,083       2,858  
Shareholders’ equity (1)
     24,439       201       24,640       22,123       690       22,813  
 
 
   $ 600,346     $ 23,219     $ 623,565     $ 536,780     $ 19,583     $ 556,363  
 
(1)   Included in our consolidated earnings as at October 31, 2007 was $407 million (2006 - $293 million) of undistributed earnings of our joint ventures and investments accounted for using the equity method under U.S. GAAP.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  163

 

 

 
NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
Condensed Consolidated Statements of Income
                         
 
    2007     2006     2005  
 
Net income from continuing operations, Canadian GAAP
   $ 5,492     $ 4,757     $ 3,437  
Differences:
                        
Net interest income
                        
Derivative instruments and hedging activities
     (17 )     (22 )     36  
Joint ventures
     (115 )     (75 )     —  
Liabilities and equity
     115       115       115  
Non-interest income
                        
Insurance accounting
     (202 )     (544 )     (606 )
Derivative instruments and hedging activities
     56       (31 )     11  
Reclassification of financial instruments (1)
     9       14       27  
Variable interest entities
     4       (10 )     —  
Limited partnerships
     60       (3 )     (9 )
Joint ventures
     (650 )     (458 )     (171 )
Reclassification of foreign currency translation
     (41 )     (4 )     —  
Other
     (31 )     (29 )     (4 )
Provision for (recovery of) credit losses
                        
Joint ventures
     4       2       18  
Other
     (8 )     —       —  
Insurance policyholder benefits, claims and acquisition expense
                        
Insurance accounting
     137       471       584  
Non-interest expense
                        
Stock appreciation rights
     11       16       25  
Insurance accounting
     69       75       72  
Joint ventures
     653       440       118  
Variable interest entities
     2       2       —  
Other
     31       29       —  
Income taxes and net difference in income taxes due to the above items
     66       95       (13 )
Non-controlling interest in net income of subsidiaries
                        
Variable interest entities
     (6 )     8       —  
Joint ventures
     3       3       —  
Liabilities and equity
     (101 )     (101 )     (101 )
 
Net income from continuing operations, U.S. GAAP
   $ 5,541     $ 4,750     $ 3,539  
 
Net loss from discontinued operations, Canadian GAAP (2)
   $ —     $ (29 )   $ (50 )
Difference — Other
     —       —       5  
 
Net loss from discontinued operations, U.S. GAAP (2)
   $ —     $ (29 )   $ (45 )
 
Net income, U.S. GAAP
   $ 5,541     $ 4,721     $ 3,494  
 
Basic earnings per share (3)
                        
Canadian GAAP
   $ 4.24     $ 3.65     $ 2.61  
U.S. GAAP
   $ 4.26     $ 3.62     $ 2.67  
Basic earnings per share from continuing operations
                        
Canadian GAAP
   $ 4.24     $ 3.67     $ 2.65  
U.S. GAAP
   $ 4.26     $ 3.64     $ 2.71  
Basic earnings (loss) per share from discontinued operations (2)
                        
Canadian GAAP
   $ —     $ (.02 )   $ (.04 )
U.S. GAAP
   $ —     $ (.02 )   $ (.04 )
 
                        
Diluted earnings per share (3)
                        
Canadian GAAP
   $ 4.19     $ 3.59     $ 2.57  
U.S. GAAP
   $ 4.21     $ 3.57     $ 2.63  
Diluted earnings per share from continuing operations
                        
Canadian GAAP
   $ 4.19     $ 3.61     $ 2.61  
U.S. GAAP
   $ 4.21     $ 3.59     $ 2.67  
Diluted earnings (loss) per share from discontinued operations (2)
                        
Canadian GAAP
   $ —     $ (.02 )   $ (.04 )
U.S. GAAP
   $ —     $ (.02 )   $ (.04 )
 
(1)   Reclassification of financial instruments reflects differences in classification arising from the use of the fair value option and reclassification of securities. Prior to the adoption of the new financial instruments accounting standards on November 1, 2006, this item reflected the reclassification of securities only. Please refer to material differences between Canadian and U.S. GAAP for details of this reclassification of securities.
 
(2)   Refer to Note 11.
 
(3)   The impact of calculating earnings per share using the two-class method reduced U.S. GAAP basic and diluted earnings per share for all periods presented by less than one cent. Please refer to material differences between Canadian and U.S. GAAP for details of this two-class method.
Royal Bank of Canada: Annual Report 2007
164   Consolidated Financial Statements

 

 

Condensed Consolidated Statements of Cash Flows (1)
                         
 
    2007     2006     2005  
 
Cash flows from (used in) operating activities, Canadian GAAP
   $ 19,473     $ (14,996 )   $ (29,527 )
U.S. GAAP adjustment for net income
     49       (8 )     102  
Adjustments to determine net cash from (used in) operating activities
                        
Provision for credit losses
     4       (2 )     (18 )
Depreciation
     (24 )     (20 )     (4 )
Future income taxes
     (416 )     271       (135 )
Amortization of other intangibles
     (26 )     (20 )     —  
Net gain on sale of investment securities
     —       —       3  
Changes in operating assets and liabilities
                        
Insurance claims and policy benefit liabilities
     (156 )     43       (438 )
Net change in accrued interest receivable and payable
     293       (120 )     (1 )
Current income taxes
     64       —       —  
Derivative assets
     1,012       440       41  
Derivative liabilities
     (624 )     (267 )     (90 )
Trading securities
     (5,546 )     (695 )     (710 )
Reinsurance recoverable
     (42 )     (8 )     (511 )
Net change in brokers and dealers receivable and payable
     344       3,872       (2,504 )
Other
     (437 )     2,446       2,099  
 
Net cash from (used in) operating activities, U.S. GAAP
     13,968       (9,064 )     (31,693 )
 
Cash flows from (used in) investing activities, Canadian GAAP
     (36,690 )     (43,235 )     (7,727 )
Change in interest-bearing deposits with banks
     213       4,191       48  
Change in loans, net of loan securitizations
     2,084       1,050       28  
Proceeds from sale of investment securities
     (7,565 )     (14,709 )     (25,628 )
Proceeds from maturity of investment securities
     (18,784 )     (28,203 )     (18,405 )
Purchases of investment securities
     24,097       38,474       36,373  
Proceeds from sale of available-for-sale securities
     7,565       14,727       25,651  
Proceeds from maturity of available-for-sale securities
     18,784       28,185       18,379  
Purchases of available-for-sale securities
     (19,964 )     (38,383 )     (36,130 )
Net acquisitions of premises and equipment
     40       73       12  
Change in assets purchased under reverse repurchase agreements and securities borrowed
     115       2,148       —  
 
Net cash from (used in) investing activities, U.S. GAAP
     30,105       (35,682 )     (7,399 )
 
Cash flows from financing activities, Canadian GAAP
     17,374       57,711       38,666  
Change in deposits
     (17,831 )     (36,663 )     (35,001 )
Change in deposits — Canada
     (2,792 )     (299 )     15,522  
Change in deposits — International
     17,813       27,468       19,791  
Issue of RBC Trust Capital Securities
     —       —       (1,200 )
Issue of preferred shares
     (16 )     (7 )     —  
Redemption of preferred shares for cancellation
     5       —       —  
Issuance costs
     11       7       3  
Issue of common shares
     (1 )     1       (1 )
Sales of treasury shares
     3       —       —  
Purchase of treasury shares
     (1 )     (2 )     7  
Dividends paid
     (15 )     (13 )     (14 )
Change in obligations related to assets sold under repurchase agreements and securities loaned
     (149 )     (1,141 )     —  
Dividends/distributions paid by subsidiaries to non-controlling interests
     (101 )     (102 )     (102 )
Change in obligations related to securities sold short
     2,017       (2,835 )     2,837  
Change in short-term borrowings of subsidiaries
     —       —       (4 )
 
Net cash from financing activities, U.S. GAAP
   $ 16,317     $ 44,125     $ 40,504  
 
Effect of exchange rate changes on cash and due from banks
   $ (332 )   $ (80 )   $ (122 )
 
Net change in cash and due from banks
     (152 )     (701 )     1,290  
Cash and due from banks at beginning of year
   $ 4,300     $ 5,001     $ 3,711  
 
Cash and due from banks at end of year, U.S. GAAP
   $ 4,148     $ 4,300     $ 5,001  
 
(1)   We did not have any discontinued operations during 2007.
Accumulated other comprehensive (loss), net of taxes (1)
                                         
 
    2007        
    Canadian GAAP     Differences     U.S. GAAP     2006 (1)     2005 (1)  
 
Transition adjustment
   $ (45 )   $ 45     $ —     $ —     $ —  
Unrealized (losses) gains on available-for-sale securities
     (65 )     133       68       191       83  
Unrealized foreign currency translation gains (losses), net of hedging activities
     (3,207 )     (4 )     (3,211 )     (2,000 )     (1,768 )
Gains (losses) on derivatives designated as cash flow hedges
     111       (91 )     20       (52 )     (165 )
Additional pension obligation
     —       (541 )     (541 )     (62 )     (313 )
 
Accumulated other comprehensive income (loss), net of income taxes
   $ (3,206 )   $ (458 )   $ (3,664 )   $ (1,923 )   $ (2,163 )
 
(1)   The concept of AOCI was introduced under Canadian GAAP upon the adoption of Section 1530 on November 1, 2006 (refer to Note 1). Accordingly, there is no reconciliation for the prior periods presented.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements   165

 

 

 
NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
Consolidated Statements of Comprehensive Income
                                         
 
    2007              
    Canadian GAAP     Differences     U.S. GAAP     2006 (1)     2005 (1)  
 
Net income
   $ 5,492     $ 49     $ 5,541     $ 4,721     $ 3,494  
Other comprehensive income, net of taxes
                                        
Net unrealized (losses) gains on available-for-sale securities, net of reclassification adjustments
     (65 )     (58 )     (123 )     108       (95 )
Unrealized foreign currency translation gains (losses)
     (2,965 )     (49 )     (3,014 )     (507 )     (623 )
Reclassification of (gains) losses on foreign currency translation to income
     (42 )     41       (1 )     6       5  
Net foreign currency translation gains (losses) from hedging activities
     1,804       —       1,804       269       401  
Net gains (losses) on derivatives designated as cash flow hedges
     80       1       81       (35 )     (97 )
Reclassification to income of (gains) losses on derivatives designated as cash flow hedges
     31       (5 )     26       148       124  
Additional pension obligation
     —       50       50       251       (246 )
 
Total comprehensive income
   $ 4,335     $ 29     $ 4,364     $ 4,961     $ 2,963  
 
Income taxes (recovery) deducted from the above items:
                                        
Net unrealized gains (losses) on available-for-sale securities
   $ (11 )   $ (37 )   $ (48 )   $ 57     $ (55 )
Net foreign currency translation gains (losses), net of hedging activities
     911       —       911       130       204  
Net unrealized gains (losses) on derivatives designated as cash flow hedges
     43       —       43       (15 )     (51 )
Reclassification to income of (gains) losses on derivatives designated as cash flow hedges
     16       (3 )     13       75       66  
Additional pension obligation
     —       27       27       134       (132 )
 
Total income taxes (recovery)
   $ 959     $ (13 )   $ 946     $ 381     $ 32  
 
(1)   A new Consolidated Statement of Comprehensive Income was introduced under Canadian GAAP upon adoption of Section 1530 on November 1, 2006 (refer to Note 1). Accordingly, there is no reconciliation for the prior periods presented.
Material balance sheet reconciling items
The following tables present the increases or (decreases) in assets, liabilities and shareholders’ equity by material differences between Canadian and U.S. GAAP:
                                                                                                                 
 
                                                                                                    Guarantees,        
                                                                                                  loan        
    Derivatives     Variable                     Reclassification             Stock             Additional     Trade             Right     commitments        
    and hedging     interest     Joint     Insurance     of financial     Limited     appreciation     Liabilities     pension     date     Non-cash     of     and other        
As at October 31, 2007   activities     entities     ventures     accounting     instruments (1)     partnerships     rights     and equity     obligation     accounting     collateral     offset     minor items (2)     Total  
 
Assets
                                                                                                                
Cash and due from banks
   $ —       —       (78 )     —       —       —       —       —       —       —       —       —       —     $ (78 )
Interest-bearing deposits with banks
   $ —       —       (4,436 )     —       —       —       —       —       —       —       —       —       —     $ (4,436 )
Securities
   $ —       —       (375 )     —       (875 )     (195 )     —       —       —       2,422       —       —       1     $ 978  
Assets purchased under reverse repurchase agreements and securities borrowed
   $ —       —       (2,262 )     —       (1 )     —       —       —       —       —       —       —       —     $ (2,263 )
Loans
   $ —       —       (2,931 )     —       (18 )     —       —       —       —       —       —       717       44     $ (2,188 )
Other assets
   $ (2 )     —       (4,818 )     2,967       873       220       (23 )     —       (202 )     13,995       18,106       —       90     $ 31,206  
Liabilities and shareholders’ equity
                                                                                                                
Deposits
   $ (8 )     —       (12,277 )     —       13       —       —       —       —       —       —       —       (4 )   $ (12,276 )
Other liabilities
   $ 2       —       (2,594 )     2,728       (14 )     —       (60 )     (34 )     339       16,417       18,106       717       (24 )   $ 35,583  
Subordinated debentures
   $ —       —       —       —       6       —       —       —       —       —       —       —       —     $ 6  
Trust capital securities
   $ —       —       —       —       —       —       —       (1,400 )     —       —       —       —       —     $ (1,400 )
Preferred share liabilities
   $ —       —       —       —       —       —       —       (300 )     —       —       —       —       —     $ (300 )
Non-controlling interest in subsidiaries
   $ —       —       (29 )     —       —       —       —       1,434       —       —       —       —       —     $ 1,405  
Shareholders’ equity
   $ 4       —       —       239       (26 )     25       37       300       (541 )     —       —       —       163     $ 201  
 
(1)   Reclassification of financial instruments reflects differences in classification arising from the use of the fair value option and reclassification of securities. Prior to the adoption of the new financial instruments accounting standards on November 1, 2006, this column reflected the reclassification of securities only. Refer to the material differences between Canadian and U.S. GAAP for details of this reclassification of securities.
 
(2)   Other minor differences include cumulative translation adjustment of $41 million (2006 — $4 million) and $8 million ($nil for 2006) related to loans held for sale which are recorded at the lower of cost or market under U.S. GAAP and recorded at amortized cost under Canadian GAAP.
Royal Bank of Canada: Annual Report 2007
166   Consolidated Financial Statements

 

 

                                                                                                                 
 
                                                                                                    Guarantees,        
                                                                                                  loan        
    Derivatives     variable                                     Stock             Additional     Trade             Right     commitments        
    and hedging     interest     Joint     Insurance     Reclassification     Limited     appreciation     Liabilities     pension     date     Non-cash     of     and other        
As at October 31, 2006   activities     entities     ventures     accounting     of securities(1)     partnerships     rights     and equity     obligation     accounting     collateral     offset     minor items     Total  
 
Assets
                                                                                                                
Cash and due from banks
   $ —       —       (101 )     —       —       —       —       —       —       —       —       —       —     $ (101 )
Interest-bearing deposits with banks
   $ (33 )     —       (4,190 )     —       —       —       —       —       —       —       —       —       —     $ (4,223 )
Securities
   $ —       (342 )     (288 )     —       369       (179 )     —       —       —       60       —       —       1     $ (379 )
Assets purchased under reverse repurchase agreements and securities borrowed
   $ —       —       (2,148 )     —       —       —       —       —       —       —       —       —       —     $ (2,148 )
Loans
   $ 41       —       (1,004 )     —       —       —       —       —       —       —       —       852       —     $ (111 )
Other assets
   $ 321       (2 )     (3,723 )     2,890       (128 )     164       (22 )     —       (25 )     10,401       16,558       —       111     $ 26,545  
Liabilities and shareholders’ equity
                                                                                                                
Deposits
   $ 52       —       (9,518 )     —       —       —       —       —       —       —       —       —       —     $ (9,466 )
Other liabilities
   $ (77 )     (39 )     (1,907 )     2,777       —       —       (58 )     (34 )     37       10,461       16,558       852       87     $ 28,657  
Subordinated debentures
   $ 300       —       —       —       —       —       —       —       —       —       —       —       —     $ 300  
Trust capital securities
   $ —       —       —       —       —       —       —       (1,383 )     —       —       —       —       —     $ (1,383 )
Preferred share liabilities
   $ —       —       —       —       —       —       —       (298 )     —       —       —       —       —     $ (298 )
Non-controlling interest in subsidiaries
   $ —       (305 )     (29 )     —       —       —       —       1,417       —       —       —       —       —     $ 1,083  
Shareholders’ equity
   $ 54       —       —       113       241       (15 )     36       298       (62 )     —       —       —       25     $ 690  
 
(1)   Reclassification of financial instruments reflects differences in classification arising from the use of the fair value option and reclassification of securities. Prior to the adoption of the new financial instruments accounting standards on November 1, 2006, this column reflected the reclassification of securities only. Refer to the material differences between Canadian and U.S. GAAP for details of this reclassification of securities.
Material differences between Canadian and U.S. GAAP
             
No.   Item   U.S. GAAP   Canadian GAAP
 
1
  Variable interest
entities 		  We consolidate VIEs where we are the entity’s Primary Beneficiary under Financial Accounting Standards Board (FASB) Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46R). VIEs are entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The Primary Beneficiary is the party that has exposure to a majority of the expected losses and/or expected residual returns of the VIE.   The accounting for VIEs is consistent in all material aspects with U.S. GAAP. In the second quarter of 2007, we adopted EIC-163 which is substantially the same as FSP FIN 46(R)-6. Refer to Note 1.
 
           In the fourth quarter of 2006, we adopted FASB Staff Position FIN 46(R)-6, Determining the Variability to be Consolidated in Applying FASB Interpretation No. 46(R) (FSP FIN 46(R)-6). This guidance provides additional clarification on how to analyze VIEs and their consolidation requirements. Upon adoption of this guidance, we deconsolidated certain investment funds.    
 
2
  Liabilities and equity   Shares issued with conversion or conditional redemption features are classified as equity. Shares that are mandatorily redeemable because there is an unconditional obligation requiring the issuer to redeem the instrument by transferring its assets upon a specified date or upon an event that is certain to occur are classified as liabilities.   Financial instruments that can be settled by a variable number of our common shares upon their conversion by the holder are classified as liabilities under Canadian GAAP. As a result, certain of our preferred shares and TruCS are classified as liabilities. Dividends and yield distributions on these instruments are included in Interest expense in our Consolidated Statements of Income.
 
3
  Derivative instruments and hedging activities   All derivatives are recorded on our Consolidated Balance Sheets at fair value, including certain derivatives embedded within hybrid instruments. For derivatives that do not qualify for hedge accounting, changes in their fair value are recorded in Non-interest income. For derivatives that are designated and qualify as cash flow hedges, changes in fair value related to the effective portion of the hedge are recorded in AOCI within Shareholders’ equity, and will be subsequently recognized in Net interest income in the same period when the cash flow of the hedged item affects earnings. The ineffective portion of the hedge is reported in Non-interest income.   Prior to November 1, 2006, derivatives embedded within hybrid instruments generally were not separately accounted for except for those related to equity-linked deposit contracts. For derivatives that did not qualify for hedge accounting, changes in their fair value were recorded in Non-interest income. Non-trading derivatives where hedge accounting had not been applied upon adoption of Accounting Guideline 13, Hedging Relationships, were recorded at fair value with transition gains or losses being recognized in income as the original hedged item affects Net interest income. Where derivatives had been
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  167

 

 

 
NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
Material differences between Canadian and U.S. GAAP (continued)
             
No.   Item   U.S. GAAP   Canadian GAAP
 
3
  Derivative instruments and hedging activities (continued)   For derivatives that are designated and qualify as fair value hedges, the carrying amount of the hedged item is adjusted by gains or losses attributable to the hedged risk and recorded in Non-interest income. This change in fair value of the hedged item is generally offset by changes in the fair value of the derivative.   designated and qualified as effective hedges, they were accounted for on an accrual basis with gains or losses deferred and recognized over the life of the hedged assets or liabilities as adjustments to Net interest income. The ineffective portion of the hedge was not required to be recognized.
     Upon the adoption of Section 3855 and Section 3865 on November 1, 2006, Canadian GAAP is substantially harmonized with U.S. GAAP. Refer to Note 1.
 
4
  Joint ventures   Investments in joint ventures other than VIEs are accounted for using the equity method.   Investments in joint ventures other than VIEs are proportionately consolidated.
 
5
  Insurance
accounting 		  Fixed income and equity investments are included in Available-for-sale securities and are carried at estimated fair value. Unrealized gains and losses, net of income taxes, are reported in AOCI within Shareholders’ equity. Realized gains and losses are included in Non-interest income when realized.   Prior to November 1, 2006, fixed income and equity investments were classified as Investment account securities. Fixed income investments were carried at amortized cost, and equity investments at cost except for those that support life insurance liabilities whose carrying values were adjusted quarterly by 5% of the difference between market value and previously adjusted carrying cost. Realized gains and losses on disposal of fixed income investments that support life insurance liabilities were deferred and amortized to Non-interest income over the remaining term to maturity of the investments sold to a maximum period of 20 years. Realized gains and losses on disposal of equity investments were deferred and recognized as Non-interest income at the quarterly rate of 5% of unamortized deferred gains and losses.
 
            
 
          Upon adoption of Section 3855 on November 1, 2006, fixed income and equity securities are classified as available-for-sale securities except for those supporting the policy benefit liabilities of life and health insurance contracts which are designated as held-for-trading using the fair value option, as described in Note 1.
 
            
 
      Insurance claims and policy benefit liabilities: Liabilities for life insurance contracts, except universal life and investment-type contracts, are determined using the net level premium method, which includes assumptions for mortality, morbidity, policy lapses, surrenders, investment yields, policy dividends and direct operating expenses. These assumptions are not revised unless it is determined that existing deferred acquisition costs cannot be recovered. For universal life and investment-type contracts, liabilities represent policyholder account balances and include a net level premium reserve for some contracts. The account balances represent an accumulation of gross deposits received plus credited interest less withdrawals, expenses and mortality charges. Underlying reserve assumptions of these contracts are subject to review at least annually. Property and casualty claim liabilities represent the estimated amounts required to settle all unpaid claims, and are recorded on an undiscounted basis.   Insurance claims and policy benefit liabilities: Liabilities for life insurance contracts are determined using the Canadian Asset Liability Method, which incorporates assumptions for mortality, morbidity, policy lapses, surrenders, investment yields, policy dividends and maintenance expenses. To recognize the uncertainty in the assumptions underlying the calculation of the liabilities, a margin (provision for adverse deviations) is added to each assumption. These assumptions are reviewed at least annually and updated in response to actual experience and market conditions. Property and casualty claim liabilities represent the estimated amounts required to settle all unpaid claims, and are recorded on a discounted basis.
Royal Bank of Canada: Annual Report 2007
168  Consolidated Financial Statements

 

 

Material differences between Canadian and U.S. GAAP (continued)
             
No.   Item   U.S. GAAP   Canadian GAAP
 
5
  Insurance
accounting
(continued) 		  Insurance revenue: Amounts received for universal life and other investment-type contracts are not included as revenue, but are reported as deposits to policyholders’ account balances in Insurance claims and policy benefit liabilities. Revenue from these contracts are limited to amounts assessed against policyholders’ account balances for mortality, policy administration and surrender charges, and are included in Non-interest income when earned. Payments upon maturity or surrender are reflected as reductions in the Insurance claims and policy benefit liabilities.   Insurance revenue: Premiums for universal life and other investment-type contracts are recorded as Non-interest income, and a liability for future policy benefits is established as a charge to Insurance policyholder benefits, claims and acquisition expense.
 
            
 
      Policy acquisition costs: Acquisition costs are deferred in Other assets. The amortization method of the acquisition costs is dependent on the product to which the costs are related. For long-duration contracts, they are amortized in proportion to premium revenue. For universal life and investment-type contracts, amortization is based on a constant percentage of estimated gross profits.   Policy acquisition costs: The costs of acquiring new life insurance and annuity business are implicitly recognized as a reduction in Insurance claims and policy benefit liabilities.
 
            
 
      Value of business acquired: The value of business acquired (VOBA) is determined at the acquisition date and recorded as an asset. The VOBA asset is amortized and charged to income using the same methodologies used for policy acquisition cost amortization but reflecting premiums or profit margins after the date of acquisition only.   Value of business acquired: The value of life insurance in-force policies acquired in a business combination is implicitly recognized as a reduction in policy benefit liabilities.
 
            
 
      Reinsurance: Reinsurance recoverables are recorded as an asset on our Consolidated Balance Sheets.   Reinsurance: Reinsurance recoverables of life insurance business related to the risks ceded to other insurance or reinsurance companies are recorded as an offset to Insurance claims and policy benefit liabilities.
 
            
 
      Separate accounts: Separate accounts are recognized on our Consolidated Balance Sheets.   Separate accounts: Assets and liabilities of separate accounts (known as segregated funds in Canada) are not recognized on our Consolidated Balance Sheets.
 
6
  Reclassification of securities and the application of the fair value option   Securities are classified as Trading account or Available-for-sale, and are carried on our Consolidated Balance Sheets at their estimated fair value. The net unrealized gain (loss) on Available-for-sale securities, net of related income taxes, is reported in AOCI within Shareholders’ equity except where the Available-for-sale securities qualify as hedged items in fair value hedges. These hedged unrealized gains (losses) are recorded in Non-interest income where they are generally offset by the changes in fair value of the hedging derivatives. Writedowns to reflect other-than-temporary impairment in the value of Available-for-sale securities are included in Non-interest income.   Prior to November 1, 2006, securities were classified as Trading account (carried at estimated fair value), Investment account (carried at amortized cost) or Loan substitute. Writedowns to reflect other-than-temporary impairments in the value of Investment account securities were included in Non-interest income. Loan substitute securities were accorded the accounting treatment applicable to loans and, if required, were reduced by an allowance.
 
            
 
      On November 1, 2006, we adopted Financial Accounting Standards Board (FASB) Statement No. 155, Accounting for Certain Hybrid Financial Instruments — an amendment of FASB Statements No. 133 and 140 (FAS 155). FAS 155 allows an entity to measure any hybrid financial instrument that contains an embedded derivative that requires bifurcation at its fair value, with changes in fair value recognized in earnings.
     On November 1, 2006, we also adopted FASB Statement No. 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140 (FAS 156). Under FAS 156, an entity is required to initially measure its servicing rights at fair value and can elect to subsequently amortize its initial fair value over the term of the servicing rights, or remeasure them at fair value with changes recognized in 		  With the adoption of Section 3855 on November 1, 2006, Canadian GAAP is substantially harmonized with U.S. GAAP. The significant difference subsequent to the adoption of this new Canadian standard primarily relates to the use of the fair value option. As described in Note 1, Section 3855 allows the designation of any financial instrument as held-for-trading on its initial recognition or upon adoption of the new standard. The fair value option can be applied to any financial instrument under Canadian GAAP (except for certain restrictions imposed by the OSFI) whereas U.S. GAAP only allows the use of the fair value option for servicing rights and certain hybrid financial instruments. The principal categories of financial instruments where we have applied the fair value option under Canadian GAAP are described in Note 1.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  169

 

 

NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
Material differences between Canadian and U.S. GAAP (continued)
             
No.   Item   U.S. GAAP   Canadian GAAP
 
6
   Reclassification of securities and the application of the fair value option (continued)   Net income. The ability to remeasure servicing rights at fair value through Net income eliminates the accounting mismatch between the servicing rights and the related derivatives that would otherwise result in the absence of hedge accounting.    
 
            Upon adoption of FAS 155 and FAS 156, certain hybrid financial instruments and servicing rights are measured at fair value. The adoption of these standards did not materially impact our consolidated financial position or results of operations.    
 
7
   Limited partnerships   The equity method is used to account for investments in limited partnerships that are non-VIEs or unconsolidated VIEs, if we own at least 3% of the total ownership interest.   We use the equity method to account for investments in limited partnerships that are non-VIEs or unconsolidated VIEs, if we have the ability to exercise significant influence, generally indicated by an ownership interest of 20% or more.
 
8
   Stock appreciation
rights (SARs)		   Between November 29, 1999, and June 5, 2001, grants of options under the employee stock option plan were accompanied with tandem SARs, whereby participants could choose to exercise a SAR instead of the corresponding option. In such cases, the participants would receive a cash payment equal to the difference between the closing price of our common shares on the day immediately preceding the day of exercise and the exercise price of the option. For such a plan, compensation expense would be measured using estimates based on past experience of participants exercising SARs rather than the corresponding options.   For such a plan, a liability is recorded for the potential cash payments to participants and compensation expense is measured assuming that all participants will exercise SARs.
 
            On November 1, 2005, we adopted FASB Statement No. 123 (revised 2004) Share-Based Payment (FAS 123(R)) and its related FASB Staff Positions (FSPs) prospectively for new awards and the unvested portion of existing awards. FAS
123(R) requires that the compensation expense should be measured assuming that all participants will exercise SARs. Under the transition guidelines of the new standard, the requirements of the new accounting standard are applicable to awards granted after the adoption of the new standard. Since these SARs were awarded prior to adoption of the new accounting standard, these will continue to be accounted for under the previous accounting standard.		    
 
9
  Pension and other post- employment obligations   On October 31, 2007, we adopted the recognition requirements of FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R) (FAS 158), which require an entity to: (i) recognize the funded status of a benefit plan on the balance sheet; and (ii) recognize in OCI the existing unrecognized net actuarial gains and losses, prior service costs and credits, and net transitional assets or obligations. The measurement requirement of FAS 158, which requires an entity to measure defined benefit plan assets and obligations as at the year-end date, will be effective for us prospectively at the end of year 2009. The impact of adopting FAS 158 is disclosed in the Pensions and other post-employment benefits section of this note.   Canadian GAAP does not have the same requirements as FAS 158.

For a defined benefit plan, the plan assets and the benefit obligations may be measured as of a date not more than three months prior to the year-end. We measure our benefit obligations and pension plan assets as at September 30 each year.
 
           Prior to 2007, for defined benefit pension plans, an unfunded accumulated benefit obligation was recorded as an    
Royal Bank of Canada: Annual Report 2007
170  Consolidated Financial Statements

 

 

Material differences between Canadian and U.S. GAAP (continued)
             
No.   Item   U.S. GAAP   Canadian GAAP
 
9
  Pension and other post- employment obligations (continued)   additional minimum pension liability, an intangible asset was recorded up to the amount of unrecognized prior service cost, and the excess of unfunded accumulated benefit obligation over unrecognized prior service cost was recorded as a reduction in Other comprehensive income.    
 
10
  Trade date
accounting 		  For securities transactions, trade date basis of accounting is used for both our Consolidated Balance Sheets and our Consolidated Statements of Income.   For securities transactions, settlement date basis of accounting is used for our Consolidated Balance Sheets whereas trade date basis of accounting is used for our Consolidated Statements of Income.
 
11
  Non-cash collateral   Non-cash collateral received in securities lending transactions is recorded on our Consolidated Balance Sheets as an asset and a corresponding obligation to return it is recorded as a liability, if we have the ability to sell or repledge it.   Non-cash collateral received in securities lending transactions is not recognized on our Consolidated Balance Sheets.
 
12
  Right of offset   When financial assets and liabilities are subject to a legally enforceable right of offset and we intend to settle these assets and liabilities with the same party either on a net basis or simultaneously, the financial assets and liabilities may be presented on a net basis.   Net presentation of financial assets and liabilities is required when the same criteria under U.S. GAAP are met. In addition, the netting criteria may be applied to a tri-party transaction.
 
13
  Guarantees   For guarantees issued or modified after December 31, 2002, a liability is recognized at the inception of a guarantee, for the fair value of the obligation undertaken in issuing the guarantee.   Prior to November 1, 2006, Canadian GAAP only provides for disclosure requirements.
     Upon the adoption of Section 3855 on November 1, 2006, Canadian GAAP is substantially harmonized with U.S. GAAP.
 
14
  Loan commitments   For loan commitments entered into after March 31, 2004 and issued for loans that will be held for sale when funded, revenue associated with servicing assets embedded in these commitments should be recognized only when the servicing asset has been contractually separated from the underlying loans.   Upon adoption of Section 3855, loan commitments that can be settled net or when there is a past practice of selling the assets resulting from the loan commitments shortly after origination can be treated as derivatives and such treatment applies to all loan commitments in the same class.
     In addition, loan commitments can be designated as held-for-trading on their initial recognition or upon adoption of the new standard using the fair value option (refer to Item No. 6 above).
 
15
  Two-class method of calculating earnings per share   When calculating earnings per share, we are required to give effect to securities or other instruments or contracts that entitle their holders to participate in undistributed earnings when such entitlement is nondiscretionary and objectively determinable.   Canadian GAAP does not have such a requirement.
 
16
  Income taxes   In addition to the tax impact of the differences outlined above, the effects of changes in tax rates on deferred income taxes are recorded when the tax rate change has been passed into law.   These effects are recorded when the tax rate change has been substantively enacted.
 
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  171

 

 

NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
Restricted net assets
Certain of our subsidiaries and joint ventures are subject to regulatory requirements of the jurisdictions in which they operate. When these subsidiaries and joint ventures are subject to such requirements, they may be restricted from transferring to us our share of their assets in the form of cash dividends, loans or advances. At October 31, 2007, restricted net assets of these subsidiaries were $10.3 billion (2006 — $7.1 billion).
Pensions and other post-employment benefits
The following information on our defined benefit plans is in addition to that disclosed in Note 20.
     On October 31, 2007, we adopted the recognition and disclosure provisions of FAS 158 which require the recognition of a plan’s over-funded or under-funded status as an asset or liability with an offsetting adjustment to AOCI net of tax. The adjustments to AOCI at adoption represent the net actuarial gains and losses, prior service costs or credits, and transitional assets or obligations that were previously unrecognized. These amounts will be subsequently recognized as pension cost as they are amortized over the expected average remaining service life of employee groups covered by the plans. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as pension cost in the same periods will be recognized as a component of OCI. These amounts will be subsequently recognized as a component of pension cost on the same basis as the amounts recognized in AOCI on adoption of FAS 158.
     The incremental effects of adopting the provisions of FAS 158 on our Consolidated Balance Sheet at October 31, 2007 are presented in the following table, including the effect of recognizing the additional minimum liability of $30 million prior to adopting FAS 158. The incremental effects of adopting the provision of FAS 158 on our Consolidated Balance Sheet at October 31, 2007 had no effect on our Consolidated Statement of Income for the year ended October 31, 2007, or for any year presented.
                         
   
    2007  
    Before application             After application  
    of FAS 158     Adjustments     of FAS 158  
 
Other assets
                        
Prepaid pension benefit cost (1)
   $ 578     $ (479 )   $ 99  
 
Other liabilities
                        
Accrued pension and other post-employment benefit expense (2)
     1,262       330       1,592  
 
Accumulated other comprehensive loss (3)
   $ 18     $ 809     $ 827  
 
(1)   Includes the reversal of $12 million unrecognized prior service costs reported as intangible asset.
 
(2)   Includes the reversal of the additional minimum liability adjustment of $30 million.
 
(3)   Includes employee benefit plan adjustments of $549 million, net of tax, and the reversal of the additional minimum liability adjustment of $20 million, net of tax.
The under-funded status of the pension plans and other post-employment plans of $52 million and $1,441 million, respectively, are recognized on our Consolidated Balance Sheet in Other liabilities. The accumulated benefit obligations for the pension plans is $6,299 million at October 31, 2007 (2006 — $6,277 million).
The pre-tax amounts included in AOCI at October 31, 2007 are as follows:
                         
   
    2007  
            Other post-        
    Pension plans     employment plans     Total  
 
Net actuarial loss
   $ 484     $ 564     $ 1,048  
Prior service cost (benefit)
     95       (307 )     (212 )
Transitional (asset) obligation
     (10 )     1       (9 )
 
Pre-tax amount recognized in Accumulated other comprehensive loss (1)
   $ 569     $ 258     $ 827  
 
(1)   Amount recognized in AOCI, net of tax is $541 million.
     
 
    
Royal Bank of Canada: Annual Report 2007
172  Consolidated Financial Statement

 

 

     The estimated net actuarial loss and prior service cost for the pension plans that will be amortized from AOCI, on a pre-tax basis, into pension expense during 2008 are $94 million and $22 million, respectively, and pension expense will be reduced by $2 million relating to the amortization of transitional assets. The estimated net actuarial loss and transitional obligation for the Other post-employment plans that will be amortized from AOCI, on a pre-tax basis, into pension expense during 2008 are $37 million and $nil, respectively, and pension expense will be reduced by $23 million relating to the amortization of prior service benefit.
Hedging activities
Upon adoption of Section 3855 and Section 3865 on November 1, 2006, Canadian GAAP is substantially harmonized with U.S. GAAP. The criteria in applying hedge accounting and the accounting for each of the permitted hedging strategies are described in Note 1.
     Prior to November 1, 2006, there were material differences between Canadian and U.S. GAAP and such differences are quantified as follows:
Fair value hedge
For the year ended October 31, 2006, the ineffective portion recognized in Non-interest income amounted to a net unrealized gain of $11 million (2005 — $4 million). All components of each derivative’s change in fair value have been included in the assessment of fair value hedge effectiveness. We did not hedge any firm commitments for the year ended October 31, 2006.
Cash flow hedge
For the year ended October 31, 2006, a net unrealized gain of $1 million (2005 — $97 million loss) was recorded in OCI for the effective portion of changes in fair value of derivatives designated as cash flow hedges. The amounts recognized in OCI are reclassified to Net interest income in the periods in which Net interest income is affected by the variability in cash flows of the hedged item. A net loss of $108 million (2005 — $124 million loss) was reclassified to Net income during the year. A net loss of $26 million (2005 — $111 million loss) deferred in AOCI as at October 31, 2006, is expected to be reclassified to Net income during the next 12 months.
     For the year ended October 31, 2006, a net unrealized loss of $23 million (2005 — $3 million loss) was recognized in Non-interest income for the ineffective portion of cash flow hedges. All components of each derivative’s change in fair value have been included in the assessment of cash flow hedge effectiveness. We did not hedge any forecasted transactions for the year ended October 31, 2006.
Hedges of net investments in foreign operations
For the year ended October 31, 2006, we experienced foreign currency losses of $507 million (2005 — $623 million) related to our net investments in foreign operations, which were offset by gains of $269 million (2005 — $401 million) related to derivative and non-derivative instruments designated as hedges for such foreign currency exposures. The net foreign currency gains (losses) are recorded as a component of OCI.
Average assets, U.S. GAAP
                                                 
   
    2007     2006     2005  
    Average     % of total     Average     % of total     Average     % of total  
    assets     average assets     assets     average assets     assets     average assets  
 
Canada
   $ 338,545       56 %   $ 297,740       57 %   $ 277,442       58 %
United States
     139,569       23 %     119,614       23 %     97,002       20 %
Other International
     125,743       21 %     104,533       20 %     101,961       22 %
 
 
   $ 603,857       100 %   $ 521,887       100 %   $ 476,405       100 %
 
Significant accounting changes
Guidance for quantifying financial statement misstatements
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). It provides guidance on how to evaluate prior period financial statement misstatements for the purpose of assessing their materiality in the current period. SAB 108 requires registrants to evaluate the materiality of identified adjusted errors using both of the follow methods: the “rollover” approach, which quantifies errors based on the amount of the errors originating in the current-year income statement without considering the effects of correcting the portion of the current-year balance sheet for misstatements that originated in prior years, and the “iron curtain” approach, which quantifies an error based on the effects of correcting the misstatement existing in the balance sheet at the end of the current year, irrespective of when it arose. SAB 108 permits companies to adjust for the cumulative effect of errors that the company previously determined to be immaterial by adjusting the carrying amount of assets and liabilities as of the beginning of the current year, with an offsetting adjustment to the opening balance of retained earnings.
     We adopted SAB 108 on November 1, 2006, and reduced our opening retained earnings and AOCI by $42 million and $35 million, respectively, and increased other liabilities by $77 million. These adjustments pertain to errors that arose between 2001 and 2006 when certain criteria were not met in order for hedge accounting to be achieved. We previously deemed these errors to be immaterial to our Consolidated Financial Statements using the rollover method.
Future accounting changes
Guidance on accounting for income taxes
FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (FIN 48), on July 13, 2006, and its related Staff Position FIN 48-1, Definition of Settlement in FASB Interpretation No. 48 (FSP FIN 48-1), on May 2, 2007. FIN 48 and FSP FIN 48-1 provide additional guidance on how to recognize, measure and disclose income tax benefits. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings. FIN 48 became effective for us on November 1, 2007, and is not expected to materially impact our consolidated financial position and results of operations.
Accounting for deferred acquisition costs for insurance operations
On September 19, 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides guidance on accounting for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, by amendment or endorsement, rider to a contract, or by the election of a feature or coverage within a contract. A replacement contract that is substantially
     
 
    
  Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  173

 

 

NOTE 31 RECONCILIATION OF THE APPLICATION OF CANADIAN AND UNITED STATES GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (continued)
changed from the replaced contract is accounted for as an extinguishment of the replaced contract, resulting in the unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from extinguished contracts being expensed. This SOP became effective for us on November 1, 2007 on a prospective basis, and is not expected to materially impact our consolidated financial position and results of operations.
Guidance for written loan commitments recorded at fair value through earnings
On November 5, 2007, the SEC issued Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings (SAB 109). It requires that the expected net future cash flows related to the associated servicing of the loan should be included in the measurement of all written loan commitments that are accounted for at fair value through earnings. In addition, internally developed intangible assets should not be recorded as part of the fair value of a derivative loan commitment. SAB 109 is effective for us on February 1, 2008. We are currently assessing the impact that this SAB will have on our consolidated financial position and results of operations.
Framework on fair value measurement
On September 15, 2006, FASB issued FASB Statement No. 157, Fair Value Measurements (FAS 157), which establishes a framework for measuring fair value in U.S. GAAP, and is applicable to other accounting pronouncements where fair value is considered to be the relevant measurement attribute. FAS 157 also expands disclosures about fair value measurements and will be effective for us on November 1, 2008. We are currently assessing the impact of adopting this standard on our consolidated financial position and results of operations.
Fair value option for financial assets and liabilities
On February 15, 2007, FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Liabilities (FAS 159). FAS 159 provides an entity the option to report selected financial assets and liabilities at fair value and establishes new disclosure requirements for assets and liabilities to which the fair value option is applied. FAS 159 will be effective for us on November 1, 2008. We are currently assessing the impact of adopting this standard on our consolidated financial position and results of operations.
Offsetting of amounts related to certain contracts
On April 30, 2007, FASB issued a Staff Position FIN 39-1, Amendment of FASB Interpretation No. 39 (FSP FIN 39-1), which amends certain aspects of FIN 39, Offsetting of Amounts Related to Certain Contracts, to permit a reporting entity to offset fair value amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) against fair value amounts recognized for derivative instruments executed with the same counterparty under the same master netting agreement. FSP FIN 39-1 will be effective for us on November 1, 2008. We are currently assessing the impact of adopting this standard on our consolidated financial position and results of operations.
Income tax benefits of dividends on share-based payment awards
At the June 27, 2007 meeting, the FASB ratified the consensus reached by the Emerging Issues Task Force (EITF) on Issue 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (EITF 06-11), on realized tax benefits on dividend payments related to certain share-based payment arrangements which can be treated as deductible compensation expense for income tax purposes. Under EITF 06-11, a realized tax benefit from dividends or dividend equivalents that are charged to retained earnings and paid to employees for equity-classified non-vested equity shares, non-vested equity share units, and outstanding share options should be recognized as an increase to additional paid-in capital (APIC). Those tax benefits are considered excess tax benefits (“windfall”) under FAS 123(R). The EITF also reached a final consensus that if an entity’s estimate of forfeitures increases (resulting in compensation expense), the amount of associated tax benefits that are reclassified from APIC to the income statement should be limited to the entity’s pool of excess tax benefits. This EITF will be effective for us on November 1, 2008. We are currently assessing the impact of adopting this standard on our consolidated financial position and results of operations.
     
 
    
Royal Bank of Canada: Annual Report 2007
174  Consolidated Financial Statement

 

 

NOTE 32 PARENT COMPANY INFORMATION
The following table presents information regarding the legal entity of Royal Bank of Canada with its subsidiaries presented on an equity accounted basis:
Condensed Balance Sheets
                 
   
    2007     2006  
 
Assets
                
Cash and due from banks
   $ 2,992     $ 2,924  
Interest-bearing deposits with banks
     5,154       2,920  
Securities
     94,603       90,076  
Investments in bank subsidiaries and associated corporations
     12,151       10,345  
Investments in other subsidiaries and associated corporations
     22,347       21,830  
Assets purchased under reverse repurchase agreements
     10,609       9,221  
Loans, net of allowances
     196,414       166,528  
Net balances due from bank subsidiaries
     18,194       24,750  
Net balances due from other subsidiaries
     9,078       10,845  
Other assets
     86,502       54,545  
 
 
   $ 458,044     $ 393,984  
 
Liabilities and shareholders’ equity
                
Deposits
   $ 306,123     $ 285,898  
Other liabilities
     121,065       78,699  
 
 
   $ 427,188     $ 364,597  
 
Subordinated debentures
   $ 6,117     $ 6,966  
Preferred share liabilities
     300       298  
Shareholders’ equity
     24,439       22,123  
 
 
   $ 458,044     $ 393,984  
 
Condensed Statements of Income
                         
   
    2007     2006     2005  
 
Interest income (1)
   $ 17,563     $ 14,007     $ 11,616  
Interest expense
     12,940       10,351       6,867  
 
Net interest income
     4,623       3,656       4,749  
Non-interest income (2)
     4,408       3,935       3,412  
 
Total revenue
     9,031       7,591       8,161  
 
Provision for credit losses
     702       410       392  
Non-interest expense
     5,905       5,720       6,001  
Business realignment charges
     —       2       44  
 
Income from continuing operations before income taxes
     2,424       1,459       1,724  
Income taxes
     454       424       528  
 
Net income before equity in undistributed income of subsidiaries
     1,970       1,035       1,196  
Equity in undistributed income of subsidiaries (3)
     3,522       3,693       2,191  
 
Net income
   $ 5,492     $ 4,728     $ 3,387  
 
(1)   Includes dividend income from investments in subsidiaries and associated corporations of $420 million, $17 million and $20 million for 2007, 2006 and 2005, respectively.
 
(2)   Includes income from associated corporations of $4 million, $8 million and $49 million for 2007, 2006 and 2005, respectively.
 
(3)   Includes net loss from discontinued operations related to RBC Mortgage of $29 million and $50 million for 2006 and 2005, respectively. Refer to Note 11.
Royal Bank of Canada: Annual Report 2007
Consolidated Financial Statements  175

 

 

NOTE 32 PARENT COMPANY INFORMATION (continued)
Condensed Statements of Cash Flows
                         
 
    2007     2006     2005  
 
Cash flows from operating activities
                        
Net income
   $ 5,492     $ 4,728     $ 3,387  
Adjustments to determine net cash from (used in) operating activities:
                        
Change in undistributed earnings of subsidiaries
     (3,522 )     (3,693 )     (2,191 )
Other operating activities, net
     11,100       (7,397 )     (17,184 )
 
Net cash from (used in) operating activities
     13,070       (6,362 )     (15,988 )
 
Cash flows from investing activities
                        
Change in interest-bearing deposits with banks
     (2,234 )     (1,192 )     1,878  
Change in loans, net of loan securitizations
     (38,896 )     (23,417 )     (23,439 )
Proceeds from loan securitizations
     6,113       5,963       3,213  
Proceeds from sale of available-for-sale securities
     2,376       —       —  
Proceeds from sale of investment securities
     —       11,233       17,149  
Proceeds from maturity of available-for-sale securities
     4,891       —       —  
Proceeds from maturity of investment securities
     —       18,195       7,434  
Purchase of available-for-sale securities
     (10,365 )     —       —  
Purchase of investment securities
     —       (25,445 )     (16,374 )
Net acquisitions of premises and equipment
     (481 )     (401 )     (310 )
Change in assets purchased under reverse repurchase agreements and securities borrowed
     (1,388 )     (388 )     516  
Net cash from (used in) investments in subsidiaries
     (2,101 )     (946 )     (326 )
Change in net funding provided to subsidiaries
     8,062       (8,734 )     (13,639 )
 
Net cash used in investing activities
     (34,023 )     (25,132 )     (23,898 )
 
Cash flows from financing activities
                        
Change in deposits
     20,225       28,989       36,542  
Issue of subordinated debentures
     87       —       800  
Repayment of subordinated debentures
     (989 )     (953 )     (786 )
Issue of preferred shares
     1,150       600       300  
Redemption of preferred shares for cancellation
     (150 )     (250 )     (132 )
Issuance costs
     (23 )     (6 )     (3 )
Issue of common shares
     155       116       198  
Purchase of common shares for cancellation
     (646 )     (844 )     (226 )
Sale of treasury shares
     208       244       179  
Purchase of treasury shares
     (133 )     (208 )     (49 )
Dividends paid
     (2,278 )     (1,807 )     (1,469 )
Change in obligations related to assets sold under repurchase agreements and securities loaned
     (553 )     3,955       1,137  
Change in obligations related to securities sold short
     3,968       1,059       3,658  
 
Net cash from financing activities
     21,021       30,895       40,149  
 
Net change in cash and due from banks
     68       (599 )     263  
Cash and due from banks at beginning of year
     2,924       3,523       3,260  
 
Cash and due from banks at end of year
   $ 2,992     $ 2,924     $ 3,523  
 
Supplemental disclosure of cash flow information
                        
Amount of interest paid in year
   $ 13,061     $ 8,971     $ 6,540  
Amount of income taxes (recovered) paid in year
   $ (165 )   $ 656     $ 1,106  
 
Royal Bank of Canada: Annual Report 2007
176  Consolidated Financial Statements