THE RISKY SIDE OF BEING CAREFUL

BANKING REPORTER

Last July, a group of senior bankers were summoned to a meeting room on the fifth floor of Canadian Imperial Bank of Commerce's headquarters in downtown Toronto to talk about one of its biggest deals in years.

The room lacked the usual accoutrements of high finance. Instead of polished wood and panoramic views, the walls seemed almost bare. But like many of the rooms where CIBC chief executive officer Gerry McCaughey liked to plot strategy, the emptiness was by design.

The blank walls were, in fact, oversized floor-to-ceiling whiteboards. They were handy tools, since Mr. McCaughey - a hyper-focused banker with a professorial bent - has been known to vault from his chair mid-sentence during a meeting to diagram ideas and scribble down notes.

By the time he called this meeting, though, the writing was already on the wall at CIBC. After years of transforming itself, pruning and culling businesses it considered too risky, the bank needed desperately to find a way to grow. And for its top executive, that really does require a new blueprint.

When Mr. McCaughey took the reins of Canada's fifth-largest bank in 2005, he was brought in as a cleanup man whose job was to stabilize the business in a time of unprecedented turbulence. Up to that point, the bank had built itself into an ambitious financial giant under the watch of John Hunkin, an investment banker focused more on capital markets than traditional bread-and-butter retail lending. But after a string of costly and embarrassing missteps in the early 2000s - including, most notably, the $2.4-billion cost of a legal settlement concerning Enron Corp.'s massive accounting fraud - Mr. McCaughey was the man called upon to play fixer.

Two years into the job, he hit a major bump: CIBC found itself on the losing end of massive trades involving complicated securities tied to the U.S. housing market. The multibillion-dollar writeoffs hit the bank's reputation - and the CEO's. Mr. McCaughey responded by buckling down, systematically changing CIBC's risk-taking ways and transforming it into a conservative lender fixated on safe, domestic banking.

Analysts have praised him for executing one of the biggest cleanup jobs in Canadian banking. But a new problem has arisen: As CEO, he now needs to find a way to push the bank forward, and keep CIBC from losing ground to its rivals.

"Nothing is free," says Canaccord Genuity analyst Mario Mendonca. "You can't reduce risk without there being some consequence. And one of the consequences is they're not growing. Their revenue growth is below their peers."

On the table at that meeting last July was a deal to address that weakness: CIBC was looking at buying a 41-per-cent stake in American Century Investments, an asset put up for sale by JPMorgan Chase & Co. It was an enticing deal, because even amid the economic upheaval ravaging the United States, the mutual fund company was a profitable business. The problem with good assets is they never come cheap.

The truth was, however, that CIBC needed a deal - needed to expand by stepping outside the comfort zone Mr. McCaughey has so carefully fenced off for the bank - and everyone in the room knew it. When the bank announced several weeks later that it was buying JPMorgan's stake for $848-million, it was by no means a blockbuster price tag by industry standards. But for CIBC it was a significant step forward - an acquisition that would help grow the bank's balance sheet almost immediately.

Now all Mr. McCaughey needs to do is duplicate that feat, several times over.

Extreme bank makeoverThe CIBC of today is almost unrecognizable from the one that existed under the erstwhile boss Mr. Hunkin.

In 1996, the bank purchased television ads with a message aimed directly at Wall Street. The commercials, which ran in heavy rotation on CNBC, were a warning shot of sorts, depicting a group of ashen-faced bankers solemnly trudging up the steps of a stately New York financial institution when, out of nowhere, a Hummer speeds past them up the stairs, presumably in the direction of the stock exchange.

"Who are those guys?" one banker asks, admiring the Hummer, that emblem of 1990s excess. "CIBC World Markets," exclaims the awestruck banker next to him.

The message was symbolic of how the bank thought about itself at the time. CIBC wanted to expand around the world and conquer new markets, taking risks and growing rapidly as it went. It saw itself as a player in the world's financial capitals, and invested heavily in its businesses in the U.S., Asia and elsewhere.

These days, CIBC has shed virtually all of its imperial swagger. Under Mr. McCaughey, the bank has largely retreated to Canada, where it relied heavily on the domestic banking market, which is stable and predictable, but where growth is increasingly hard to find.

Seated in one of his spartan strategy rooms decked out with giant whiteboards, Mr. McCaughey rests his elbows on the table and lays out his vision. It is a strategy for operating a bank that runs against everything the industry has become accustomed to over the past few decades. Unbridled growth is not quite a dirty word to him, but it's close.

"We don't want to be the fastest-growing bank," he says. In fact, he believes the industry is entering a new era of slower growth, caution, and smaller deals.

"If anyone thinks we're going back to the 'good old days,' " they are mistaken, he says. "We may never go back to that. It may be the world has permanently changed, and that financial services are no longer a growth industry. I believe it's a mature industry."

For investors, this is not necessarily welcome news. Canadians have padded their portfolios over the past 20 years with unrelenting growth in bank stocks and their dividends, which were fuelled by seemingly constant expansion into new businesses such as brokerages and insurance, new markets around the world, and an unprecedented rise in mortgage borrowing among customers at home.

But now, faced with lower interest rates, higher capital demands, highly indebted Canadian consumers, and depleted acquisition opportunities, the sector is looking less like a land of opportunity. The average bank now runs more like a utility, Mr. McCaughey argues, and the most important strategy is avoiding risk. Safe is the new daring; boring is the new benchmark for success.

"We will accept lower growth levels in order to maintain our lower risk posture," Mr. McCaughey says, choosing his words carefully.

"The world has become a very leveraged place. It was seven years ago, and it's even more leveraged today as a result of consumer debt," he says. "Part of the reason why we had a good economy [in Canada] is the consumer continued to spend. Part of the reason the consumer continued to spend is because debt levels fuelled their spending."

Statistics Canada data show the average ratio of debt-to-disposable income has risen to 152 per cent this year, up from 150.6 per cent at the end of 2011. Concerns over this magnitude of leverage has resonated in Ottawa, culminating in this week's announcement by Finance Minister Jim Flaherty that mortgage rules were being tightened again, including scaling back the maximum allowable length of a government-backed mortgage to 25 years, down from 30 years, in a bid to cool the borrowing market.

Indeed, when Mr. McCaughey took the CEO job seven years ago, he inherited a vast business built on various forms of consumer debt. In the early 2000s, sensing a fertile new breeding ground for profit, CIBC moved aggressively under Mr. Hunkin into structured credit, which was fuelling borrowing in the U.S. housing market. But when the mortgage crisis hit, CIBC got caught with billions of dollars worth of exposure to securities backed by U.S. subprime mortgages, resulting in more than $10-billion worth of writedowns.

It was a massive setback for Mr. McCaughey. To help excavate CIBC from the hole it had dug, he clawed back investment banking to focus on the more reliable business of Canadian retail banking. Then he engineered a $3-billion equity sale to shore up badly needed capital. It was an unpopular move among shareholders, since it diluted the stock considerably, but turned out to be well-timed. Within months, the North American banking sector would be in the throes of a crisis, and capital was king.

"I think it was one of the better decisions in the credit crisis," says Peter Routledge, an analyst at National Bank Financial. "CIBC exists in its current form - independent, profitable - because of that decision."

The bank that was once considered a minefield for investors is now starting to see the accolades roll in. This year, CIBC was ranked the third-strongest bank in the world, and the strongest of Canada's big banks, on a list compiled by Bloomberg Markets that scrutinized the capital levels of each financial institution. Now, more than 15 years after CIBC drove a Hummer through Wall Street in a TV commercial, the bank now advertises how safe and responsible it is.

"It's a very different bank; [McCaughey] has dramatically transformed the risk appetite," Mr. Routledge says. But, he adds: "With every blessing comes a curse."

CIBC's decision to envelop itself in the relative safety of Canadian consumer banking has left it more exposed to highly leveraged consumers than most of Canada's other major lenders. That means the bulk of CIBC's business is focused on an area that isn't going likely to grow any time soon. In the process of its dramatic makeover, CIBC may have traded one risk for another.

"The curse is that they are 50 per cent weighted towards the [Canadian] household, at a time when the household is at an all-time high of being levered," Mr. Routledge says.

"So they are sitting there with a de-risked bank, with a very profitable model, but half their balance sheet is in a low-growth asset class - that's their fundamental risk."

It's something that Mr. McCaughey knows all too well. So in the absence of other deals like the American Century acquisition, he must find other ways to position the bank for the future.

A high-class problemWhen CIBC announced this week that it was preparing to shut down its mortgage broker business, FirstLine, after failing to find a buyer, the move was symptomatic of the bank's new mindset.

For years, FirstLine was one of the largest mortgage broker operations in the country, channelling billions of dollars of new loans into CIBC from the army of salespeople it employed. But over time, McCaughey grew to dislike the business. The problem with using brokers to sell mortgages is that you had to pay them a hefty commission. So even though the bank was originating more new loans than some of its peers, it was making less money on each.

CIBC's decision to shut down FirstLine on Wednesday, and move to selling mortgages entirely through its branches, was proof of how the bank was willing to walk away from a business, even if it hurts growth. Though losing FirstLine will most definitely lead to a drop in sales, each new mortgage done through a branch should command a better margin, while also allowing the bank to sell customers on other products, like credit cards or chequing accounts.

But that and other moves - such as the bank's decision to spend billions buying back preferred shares - speak to another concern: Amid its ultra-conservative strategy, CIBC is now awash in capital and has few places to put it where it can reap a good return. It is an enviable position to be in, but the bank now faces a "high-class problem" of how to adequately deploy its funds, analyst John Reucassel at BMO Nesbitt Burns said in a research note.

While lenders in Europe and the U.S. fret about bolstering their capital reserves to meet new global regulations under the Basel III agreement, CIBC is already comfortably above the new threshold. It can afford to expend and spend money on growth - but how?

The logical place to look is acquisitions. Though not known as a deal maker, Mr. McCaughey wants to do more transactions like the American Century purchase. Wealth management in particular is an area the bank would like to explore, since the assets - which involve managing money for high-net-worth clients - don't present much risk to the bank's own balance sheet.

But investors should not expect any blockbuster deals. Mr. McCaughey says he won't tear up his low-risk strategy just to find growth. "A large transformational transaction is not consistent with the first principle of being a lower-risk bank," he says, thumping the table with his hand to press the point. "Therefore you should not expect one."

That, Mr. McCaughey explains, is banking in today's world. It's a lot less exciting, but look where risk-taking got CIBC. Boring is precisely the way he likes it.

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PAST MISTAKES

Five big blunders

Before CIBC began trying to remake itself, the bank had a well-earned a reputation for embarrassing missteps, including:

1. The Enron settlement

After becoming entangled in the accounting scandal of collapsed energy giant Enron Corp. in the early 2000s, CIBC paid $2.4-billion to settle a dispute with the company's investors.

2. Subprime mortgages

CIBC amassed billions of dollars in unhedged exposure to the subprime mortgage market in the United States, which blew up when the housing market collapsed. The bank recorded more than $10-billion in writedowns as a result.

3. Failed American dreams

Starting in the late 1990s, CIBC expanded aggressively into U.S. investment banking and launched Amicus, an electronic bank that CIBC planned to use as a beachhead into U.S. consumer market. By 2002, CIBC was retreating from those markets amid considerable losses.

4. Black eyes

The bank has suffered a number of public relations blemishes, including paying $125-million to settle allegations it gave money to hedge funds to facilitate illegal trading in mutual funds. It was also criticized by the federal Privacy Commissioner in 2004 after it was found to be errantly faxing customer information to a junk yard in Virginia.

5. Bad timing, the Asian crisis

In 1998, CIBC's global ambitions for its capital markets business took a major hit when it was blindsided by the worst of the Asian crisis. The bank's profit took a 35-per-cent hit as a result.