Southern strategy.

With the inclusion of Mexico in the North American Free Trade Agreement, Royal Bank of Canada's domain may one day embrace all of North America. But for now, Royal looks to the U.S., where it hopes to press its advantages in nationwide and electronic banking.

Visitors to Toronto are often struck by Royal Bank Plaza--an incandescent glass edifice on the corner of Front and Bay streets. The building, the creation of Toronto architect Boris Zerafa, is veneered with 2,500 ounces of real gold. Inside, there's a lobby with a cathedral ceiling; sunlight shines through, illuminating waterfalls and ponds.

Inside the plaza's South Tower one recent morning, the mood of bank officials matches the brilliant ambiance. Several hundred miles to the Southeast, at Washington's Watergate Hotel, trade ministers Carla Hills of the U.S., Michael Wilson of Canada, and Jaime Serra Puche of Mexico are hoisting champagne glasses to toast the signing of a North American Free Trade Agreement. Though the battle is just beginning in Canada and the U.S. to convince protection-minded legislators and labor leaders that the long-term benefits of creating the world's largest free market will outweigh any short-term economic hardship, Allan Taylor, chairman and CEO of Royal Bank of Canada, is beaming:

"We were a strong supporter of the Free Trade Agreement between the U.S. and Canada, and we continued on when it was decided that Mexico should join the group," he says. Free trade offers the promise of "powerful new trade relationships. These would match the clout of Europe, the Pacific Rim, or any other regional market." Ultimately, NAFTA would create a $6 trillion megamarket with 367 million consumers.

Perhaps closer to the heart for Taylor, 60, NAFTA is likely to fuel additional overseas growth for Royal, already a powerhouse in the trade finance and global foreign-exchange markets, and the dominant institution in Canada with a 25 percent share of the retail market. Royal is the fourth largest bank in North America with assets of 139.5 billion Canadian dollars ($116.4 billion). Last year, its net income inched up 1.9 percent to C$983.5 million, while ROE slipped to 15.5 percent from 17.5 percent. Amid a continuing real estate slide, earnings for the third quarter ended July 31 plunged 57 percent from the year-earlier period of C$112.4 million. The figure includes a C$390 million pre-tax provision for loan losses.

Taylor endorses NAFTA, which will allow U.S. and Canadian banks and securities firms to open wholly owned subsidiaries in Mexico and promises to lift all curbs on services they can offer there by the year 2000. But for now, Royal likely won't do much more than beef up its representative office in Mexico City: Banking follows trade, Taylor points out, and Canadian trade with Mexico amounts to a modest $2.5 billion, compared with $175 billion of business between Canada and the U.S. Still, as tariffs and other barriers are rolled back, North-South commerce doubtless will mushroom. Thus NAFTA's ratification could kick off a continentwide coming-out party for Royal. Taylor also favors the inclusion of South American countries in an even-broader free-trade agreement. Within a decade, maybe two, don't be surprised to see Royal Bank branches from the Yukon to Yucatan, and beyond.

Shorter-term, Royal has been seeking to crack the U.S. retail sector. Clearly, it would have much to bring to the party. The bank's 1,655 branches and business centers across Canada give it nationwide experience that would be critical to acquisition-minded U.S. institutions should Congress throw open the door to interstate banking. Royal's core capital ratio of 6.3 percent (6.8 percent by U.S. standards) leaves it well-positioned to bankroll the expansion of a hungry institution, most likely a well-run regional bank, Taylor says. Royal has a Midas touch with technology: Its network of 3,785 automated teller machines--second largest in the world--has enabled it to slash transaction costs. And the addition of more than 15,000 PCs with access to customer data has enhanced service and helped branch personnel to market an ever-expanding roster of products and services.

Since announcing its intentions, however, Royal has dallied on the sidelines. Taylor says the asking price for acquisitions is too steep--in some cases, nearly three times book value. He's shackled by Canadian accounting standards that require assets to be listed on the balance sheet at their sale price rather than at book value. He's disappointed by a lack of progress on interstate branching in the U.S. and Washington's failure to repeal Glass-Steagall restrictions that limit the ability of commercial institutions to engage in investment banking. (Royal has some securities underwriting abilities in the U.S. through the New York office of subsidiary RBC Dominion Securities.) But Taylor is aware that Bank of Montreal has already staked a claim south of the border: In 1984, Royal's archrival acquired $11.95 billion-asset Harris Bank in Chicago. And he allows that some U.S. banks--particularly NationsBank and Banc One--have wriggled into far-flung markets despite branching prohibitions.

"I guess we could find a way, too," Taylor says. "But I won't do anything to jeopardize our strength at home."

Excessive caution? To be sure, Royal has misstepped more than once. Along with the rest of the banking pack, it has been burned by such fads as energy and LDC loans, and most recently, by a precipitous plunge in real estate values. RBC's exposure to Olympia & York--the development firm that filed for bankruptcy protection in Canada last spring--is pegged at C$800 million (12 percent of common equity). Among Canadian banks, that's a total position second only to Canadian Imperial Bank of Commerce headquartered in Toronto.

By the end of the third quarter, Royal Bank had classified C$766 million of its exposure to Olympia & York as nonperforming. As a result of O&Y and other problem loans, in the third quarter the bank increased its estimate of its full-year 1992 loan losses from C$740 million to C$1.15 billion. Moody's le Investors Service says the Olympia & York episode probably will not result in the downgrade of RBC's senior debt, which is currently rated at Aa2. (Among North American banks, only J.P. Morgan has a higher credit rating: Aa1.)

Saskatchewan-born Taylor has a polished demeanor, the result of 43 years of global service with Royal. Incredibly, he has no university degree, having signed on with the bank as a teenager and worked his way up through the ranks. Taylor headed Royal's international division before becoming president and chief operating officer in 1983. He was named chairman and chief executive in 1986.

As head of the largest bank in Canada, he wields quasi-governmental authority: When Taylor talks about the economy or matters of state, citizens and public officials take note. Lately, he's been pushing hard for a resolution to Canada's constitutional crisis.

Until recently, Taylor acknowledges, Canada appeared to be bent on national disintegration. In line with an attempt to revise the current constitution--which Quebec refused to sign in 1981--separatist,forces in the province have demanded that PQ be recognized as a "distinct society" and that it retain a unilateral veto. Taking things a step further, the provincial legislature passed a law mandating that Quebec hold a referendum before October 26 either on sovereignty or on a binding offer from the Federal government and the other provinces. Angered by what they regard as political brinkmanship, leaders in the West countered with demands to replace Canada's appointed Senate with an elected one based on equal representation for all provinces. The Western charge has been led by Donald Getty, the premier of Alberta.

In August, however, Prime Minister Brian Mulroney and the 10 provincial premiers reached a compromise. The accord would grant special recognition to Quebec and its French-speaking majority, and create an upper chamber with broader powers. One catch: Canada's leaders must now sell voters on the new constitution. An earlier settlement, at Meech Lake in 1990, was torpedoed by two provincial premiers--Clyde Wells of New-foundland and Gary Filmon of Manitoba. The two are said to back the new, broader deal. But it's not yet clear whether Alberta and British Columbia will ratify the agreement in provincial referendums: Both are home to sizable opposition groups demanding the new Senate be structured to give the West still more power. Mulroney prefers a national referendum that would subsume those in the provinces.

Like most Canadian business leaders, Taylor favors compromise and stresses the costs of disunion. Because of the constitutional impasse, he says, investors are delaying decisions that would create more jobs and enable Canada to rebound from recession more quickly.

"It is difficult to know where to begin listing the costs a divided Canada would impose on the people," Taylor told The Canadian Club of Winnipeg in April. "The emergence of two, smaller, weaker states will almost certainly give rise to two weaker currencies. Higher interest rates; higher unemployment; much greater pain in the less prosperous regions; massive and costly production shifts; loss of international influence; disruptions to trading agreements."

Should U.S. chief executives care? "The effectiveness of NAFTA can be reduced significantly if we have a separation," Taylor warns. "If Canadians can't find a way to live together, wouldn't it follow they'll have difficulty dealing with the rest of the world?"

Against this backdrop of critical economic and political issues, Chief Executive editors J.P. Donlon and Joseph L. McCarthy met with Taylor at Royal Bank's headquarters.

EXPANDING HORIZONS

Provided the North American Free Trade Agreement gains legislative approval in the U.S., Canada, and Mexico, will it change Royal Bank's strategy at home or abroad?

We've supported the Canada-U.S. Free Trade Agreement, and we've supported the idea that Mexico should join the group in a broader North American treaty. NAFTA is good for Canada and Canadian companies. It establishes a giant market with 367 million people.

It's too early to comment on the particular opportunities the formation of such a market would present to us. But in general, it seems, Mexico has agreed to liberalize its financial services market.

Royal Bank has a representative office in Mexico City. At this time, we're not likely to rush out and buy a Mexican bank or to open a sizable branch. We would have to build up a stronger trading relationship with Mexico to have some advantage in providing broader banking services there.

Banking follows trade?

Absolutely. One of the things we've learned through experience in the international arena is that you don't open a bank and let business come to you. You open a bank in line with demand.

We went at the German market early, anticipating a consolidated Europe, as we're now seeing unfold under the Maastricht Treaty. We had a bad experience. Ultimately, we sold our operations there.

All successful international banks have a dominant position in their home markets. Of course, we bank some large companies that do business largely in their own market. But our bread and butter is providing trade financing to the top 1,000 global multinational companies.

Do you think the Canadian legislature will pass the agreement?

It will be a strenuous debate. Labor unions and parties on the Left have been very negative to NAFTA. In the end, I'm hopeful Canadians will see that the advantages outweigh the disadvantages.

Will NAFTA change your approach to the U.S. market?

The original FTA has given us an equal position with American banks. So we have a leg up on other foreign banks in the U.S. In return, of course, we have to give equal treatment to American banks operating here.

Are you concerned about competition coming into your home base?

No. With a 25 percent share of the market here, we have a pretty good shot at holding our own.

A CAPITAL IDEA

What might induce the chief executive of, say, a Texas semiconductor firm to bank with you rather than a U.S. bank?

The strength of our balance sheet. Using American standards, we've more than a 10 percent overall capital-to-assets ratio, compared with the 8 percent required under the Basle standards.

As a result, you get a much higher rating, which means you can raise funds more cheaply than many of your competitors. Are you planning any significant changes in your approach to the Canadian market?

On June 1, Canada passed a Bank Act, granting institutions opportunities in areas including insurance, trust, and information services. Royal Bank is the largest provider of payroll services in Canada. It is a leader in providing electronic credits for payroll dividends. We had been precluded from providing such services and from competing in the information business with our large technology network. That's a business in itself. We'll be looking to expand rapidly in that area.

SOUTHWARD BOUND

For several years, you've professed a desire to push south into the U.S. market, but as yet, you haven't made a move. Why the inertia?

For one thing, we have been waiting for legislative and regulatory changes in the U.S. that would allow us to get into investment banking in a more sizable way. We've also been waiting for more progress in the U.S. on interstate banking and, eventually--hopefully--nationwide banking.

Meanwhile, I gather there are other reasons for the lack of activity, beyond insufficient progress in overhauling the banking system stateside.

Well, another reason is that people want too much money. We're not prepared to pay three times book value. An acquisition of that sort involves so much goodwill that it's practically debting the bank. We're not about to do that.

With so many negatives, why expand to the U.S. at all?

The U.S. is the only place outside Canada that we have seen an opportunity to be effective with our retail banking expertise. With 1,655 branches coast-to-coast--all fully wired--we have a valuable retail franchise.

What types of acquisitions would you consider?

We might consider a large regional bank that is growing fast and might be able to benefit from the substantial capital injection we could provide.

TECH TALK

Let's talk about technology. You've received quite a boast from the dowdy, old PC.

We have wired all our branches in Canada with personal computers to serve our 8 million home-market customers. I think almost every customer service representative across the country now has a terminal on which to call up--in so-called customer service reference files--the particulars of everyone who stands at the wicket.

One example: The system automatically flags certain files with a red star. This might tell a representative to try to sell a customer a particular product--for example, a mortgage loan. Bank tellers who formerly counted up cash are now able to cross-sell products and services. That increases our productivity. From their side of the counter, Royal Bank's customers receive better service.

Another technology-based service through which you've gained a competitive advantage is ATMs.

We gain a cost advantage by completing some 65 percent of our routine transactions with ATMs. The cost per electronic transaction through our own ATMs is about 35 cents, while it's five times that for teller transactions.

That 65 percent figure is considerably higher than that at many U.S. banks: How were you able to sell so many people on electronic banking?

It has to do with getting your branch people in the marketing mode. Also, our commitment to employee training has been key. That includes both training to sell products and services and training to use our new technology.

What's your technology budget, and what proportion of your total budget does that comprise?

Our technology spending is in the neighborhood of $900 million. That's roughly 20 percent of our budget.

Others have spent at least as much on technology with much less of a return. What's your secret?

We benefited by getting involved early, particularly with ATMs. Thus we've been able to remain ahead of the learning curve.

CONSTITUTIONAL CRISIS

Canada is in the midst of a constitutional debate that threatens to split the nation in two. Why have you been so outspoken in support of unity?

I'm not a constitutional expert. But as the head of the largest financial institution in Canada, I can tell you disunity would carry tremendous costs for the residents of Quebec and the other provinces.

A view has been put forward that nothing much would change if Quebec were to secede. Some PQ officials have been saying it would be quite easy for them just to use the Canadian currency. Are you sovereign if you're using somebody else's currency and you have no say in monetary policy, taxation policy, or fiscal policy? I don't think so.

Sounds like what's being proposed by some officials in the former Soviet Union: common currency and political separatism.

It does. Europe is stumbling over the same question.

Regarding the U.S. presidential election, do you have any fears that if Bill Clinton, a Democrat, gets to the White House, protectionist sentiment will escalate?

Neither this bank nor Allan Taylor has a partisan opinion about U.S. presidential politics. But I will say this: To reap the full benefits of NAFTA, the U.S. and Canada must nurture their relationship.

I do, however, have a concern about some of the protectionism building up in the U.S. In particular, I'm referring to the disputes over softwood lumber, Hondas, and the Toyota Camry.

Let's get some of these irritants out of the way and go forward in a spirit of cooperation. Whether it's Mr. Bush or Mr. Clinton in the White House next year, I hope he will be good for the relationship.