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JPMorgan ChaseWhere our vision leads us R o y a l B a n k o f C a n a d a 2 0 0 6 A n n u a l R e p o r t Royal Bank of Canada 2006 Annual Report Where we are RBC corporate profile Royal Bank of Canada (RY on TSX and NYSE) and its subsidiaries operate under the master brand name of RBC and may be referred to in this text as 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. Our Global Technology and Operations and Global Functions teams enable business growth with expert professional advice and state-of-the-art processes and technology. We employ approximately 70,000 full- and part-time employees who serve more than 14 million personal, business, public sector and institutional clients through offices in North America and 34 countries around the world. In Canada, we have strong market positions in all of our businesses. In personal and business banking, we rank first or second in most retail products. In wealth management, we have the leading (1) full-service brokerage operation, the top mutual fund provider among Canadian banks (1) Based on assets under administration. and the second-largest (1) self-directed broker. We are the largest Canadian bank-owned insurer, one of the top 10 Canadian life insurance producers, and a leader in creditor products, travel insurance and individual disability insurance. In corporate and investment banking, we continue to be the top-ranked securities underwriter and the leading mergers and acquisitions (M&A) advisor. Our domestic delivery network is one of the most extensive of all Canadian financial services companies. In the United States, we provide personal and commercial banking, insurance, full-service brokerage and corporate and investment banking services to approximately two million clients . Outside North America, we have a banking network in the Caribbean and a significant presence in select markets. We offer investment banking, trading, correspondent banking and reinsurance to corporate, institutional, public sector and business clients. We also offer private banking and wealth management services for high net worth individuals and corporate and institutional clients. 1 2 5 6 8 10 12 13 14 17 Financial highlights Chief Executive Officer’s message Performance compared to objectives To be the undisputed leader in financial services in Canada To build on our strengths in banking, wealth management and capital markets in the United States To be a premier provider of selected global financial services Global Technology and Operations and Global Functions Chairman’s message Corporate governance Corporate responsibility 25 Management’s Discussion 99 26 33 38 and Analysis Executive summary Accounting and control matters Consolidated results from continuing operations 43 Quarterly financial information Business segment results from 45 continuing operations Financial condition Risk management Additional risks that may affect future results Additional financial information 63 72 90 92 Consolidated Financial Statements 161 Glossary 163 Directors and executive 100 Management’s responsibility for officers 164 Principal subsidiaries 165 Shareholder information financial reporting 100 Report of Independent Registered Chartered Accountants 101 Management’s report on internal control over financial reporting 101 Report of Independent Registered Chartered Accountants 102 Consolidated Balance Sheets 103 Consolidated Statements of Income 104 Consolidated Statements of Changes in Shareholders’ Equity 105 Consolidated Statements of Cash Flows 106 Notes to the Consolidated Financial Statements This annual report contains 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 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. Additional information about these factors can be found under “Caution regarding forward-looking statements” on page 25. The carbon dioxide emissions associated with the production and distribution of this report have been mitigated by Zerofootprint according to the highest standards in carbon offsetting. Form #81104 (12/2006) This report has been printed on paper stock that contains 10% post-consumer fibre and is FSC (Forest Stewardship Council) certified. FSC fibre used in the manufacture of the paper stock comes from well-managed forests independently certified by SmartWood according to Forest Stewardship Council rules. Where our vision leads us R o y a l B a n k o f C a n a d a 2 0 0 6 A n n u a l R e p o r t Royal Bank of Canada 2006 Annual Report Where we are RBC corporate profile Royal Bank of Canada (RY on TSX and NYSE) and its subsidiaries operate under the master brand name of RBC and may be referred to in this text as 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. Our Global Technology and Operations and Global Functions teams enable business growth with expert professional advice and state-of-the-art processes and technology. We employ approximately 70,000 full- and part-time employees who serve more than 14 million personal, business, public sector and institutional clients through offices in North America and 34 countries around the world. In Canada, we have strong market positions in all of our businesses. In personal and business banking, we rank first or second in most retail products. In wealth management, we have the leading (1) full-service brokerage operation, the top mutual fund provider among Canadian banks (1) Based on assets under administration. and the second-largest (1) self-directed broker. We are the largest Canadian bank-owned insurer, one of the top 10 Canadian life insurance producers, and a leader in creditor products, travel insurance and individual disability insurance. In corporate and investment banking, we continue to be the top-ranked securities underwriter and the leading mergers and acquisitions (M&A) advisor. Our domestic delivery network is one of the most extensive of all Canadian financial services companies. In the United States, we provide personal and commercial banking, insurance, full-service brokerage and corporate and investment banking services to approximately two million clients. Outside North America, we have a banking network in the Caribbean and a significant presence in select markets. We offer investment banking, trading, correspondent banking and reinsurance to corporate, institutional, public sector and business clients. We also offer private banking and wealth management services for high net worth individuals and corporate and institutional clients. 1 2 5 6 8 10 12 13 14 17 Financial highlights Chief Executive Officer’s message Performance compared to objectives To be the undisputed leader in financial services in Canada To build on our strengths in banking, wealth management and capital markets in the United States To be a premier provider of selected global financial services Global Technology and Operations and Global Functions Chairman’s message Corporate governance Corporate responsibility 25 Management’s Discussion 99 26 33 38 and Analysis Executive summary Accounting and control matters Consolidated results from continuing operations 43 Quarterly financial information Business segment results from 45 continuing operations Financial condition Risk management Additional risks that may affect future results Additional financial information 63 72 90 92 Consolidated Financial Statements 161 Glossary 163 Directors and executive 100 Management’s responsibility for officers 164 Principal subsidiaries 165 Shareholder information financial reporting 100 Report of Independent Registered Chartered Accountants 101 Management’s report on internal control over financial reporting 101 Report of Independent Registered Chartered Accountants 102 Consolidated Balance Sheets 103 Consolidated Statements of Income 104 Consolidated Statements of Changes in Shareholders’ Equity 105 Consolidated Statements of Cash Flows 106 Notes to the Consolidated Financial Statements This annual report contains 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 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. Additional information about these factors can be found under “Caution regarding forward-looking statements” on page 25. The carbon dioxide emissions associated with the production and distribution of this report have been mitigated by Zerofootprint according to the highest standards in carbon offsetting. Form #81104 (12/2006) This report has been printed on paper stock that contains 10 per cent post-consumer fibre and is FSC (Forest Stewardship Council) certified. FSC fibre used in the manufacture of the paper stock comes from well-managed forests independently certified by SmartWood according to Forest Stewardship Council rules. Vision Values Strategic goals • Always earning the right to be • Excellent service to clients our clients’ first choice and each other • Working together to succeed • Personal responsibility for high performance • To be the undisputed leader in financial services in Canada • To build on our strengths in banking, wealth management and capital markets in the United States • Diversity for growth and • To be a premier provider innovation • Trust through integrity in everything we do of selected global financial services Financial highlights (C$ millions, except per share and percentage amounts) Operating performance Total revenue Provision for credit losses Non-interest expense Net income Return on common equity (ROE) Diluted earnings per share 2006 2005 2004 $ 20,637 429 11,495 4,728 23.5% 3.59 $ $ 19,184 455 11,357 3,387 18.0% 2.57 $ $ 17,802 346 10,833 2,803 15.6% 2.11 $ 2006 vs. 2005 Increase (decrease) $ $ 1,453 8% (26) (6)% 138 1% 1,341 40% 550 bps n.m. 1.02 40% RBC Canadian Personal and Business (C$ millions, except percentage amounts) Total revenue Net income Return on equity (ROE) Average loans and acceptances Average deposits Assets under administration Assets under management 2006 2005 2004 $ 13,381 $ 12,499 $ 11,213 2,043 24.7% 145,300 133,700 157,300 58,700 2,794 31.5% 180,500 145,700 213,200 89,700 2,304 27.1% 161,500 138,800 180,300 72,100 The businesses in RBC Canadian Personal and Business continued to strengthen our leadership position in most major product categories by expanding our distribution network, enhancing our products and services, better meeting our client needs and deepening our client relationships. 2006 vs. 2005 Increase (decrease) $ 882 7% 490 21% 440 bps n.m. 19,000 12% 6,900 5% 32,900 18% 17,600 24% 9.6% 11.9% $ 223,709 9.6% 13.1% $ 197,004 8.9% 12.4% $ 183,409 – bps n.m. (120)bps n.m. $ 26,705 14% RBC U.S. and International Personal and Business Capital Tier 1 capital ratio Total capital ratio Risk-adjusted assets Key drivers Total loans (before allowance for loan losses) Total deposits Total assets Assets under management Assets under administration (1) Common share information Share price High Low Close Dividends declared per share Book value per share Market capitalization ($ millions) $ 209,939 343,523 536,780 143,100 525,800 $ 191,914 306,860 469,521 118,800 417,100 $ 172,560 270,959 426,222 102,900 391,000 $ 18,025 9% 36,663 12% 67,259 14% 24,300 21% 108,700 26% $ 51.49 41.29 49.80 1.44 16.52 63,788 $ 43.34 30.45 41.67 1.18 14.89 53,894 $ 32.95 29.02 31.70 1.01 13.57 40,877 $ 8.15 19% 10.84 36% 8.13 20% .26 22% 1.63 11% 9,894 18% Excluding Institutional & Investor Services (IIS) assets that were contributed to the joint venture RBC Dexia Investor Services on January 2, 2006. (1) n.m. not meaningful (C$ millions, except percentage amounts) Total revenue Net income Return on equity (ROE) 2006 2005 2004 2006 vs. 2005 Increase (decrease) $ 2,872 $ 444 13.6% 2,728 $ 387 11.8% 2,702 $ 214 5.4% 144 5% 57 15% 180 bps n.m. (US$ millions, except percentage amounts) 2006 2005 2004 2006 vs. 2005 Increase (decrease) Total revenue Net income Average loans and acceptances Average deposits Assets under administration Assets under management $ 2,537 $ 393 18,300 29,700 274,200 47,500 2,248 $ 320 16,900 27,400 198,400 39,500 2,057 162 14,400 25,200 191,800 36,300 $ 289 13% 73 23% 1,400 8% 2,300 8% 75,800 38% 8,000 20% The wealth management and banking businesses in RBC U.S. and International Personal and Business continued to build scale and capabilities through a combination of organic growth initiatives and acquisitions. In 2006, we expanded our distri- bution network and products and services, and focused our expansion in fast-growing markets and regions. RBC Capital Markets (C$ millions, except percentage amounts) 2006 2005 2004 2006 vs. 2005 Increase (decrease) Total revenue (teb) (1) Net income Return on equity (ROE) Average loans and acceptances Average deposits $ 4,693 $ 1,407 29.3% 23,500 118,800 4,062 760 18.1% 17,600 98,900 $ 3,933 $ 827 19.5% 18,600 88,400 631 16% 647 85% 1,120 bps n.m. 5,900 34% 19,900 20% (1) Taxable equivalent basis (teb). By successfully executing growth plans, the businesses in RBC Capital Markets maintained our position as the undisputed leader in the Canadian market, and expanded our activities in the U.S. mid market and our global infrastructure finance platform. Shareholder information Corporate headquarters Street address: Royal Bank of Canada 200 Bay Street Toronto, Ontario, Canada Tel: (416) 974-5151 Fax: (416) 955-7800 Mailing address: P.O. Box 1 Royal Bank Plaza Toronto, Ontario Canada M5J 2J5 website: rbc.com Transfer Agent and Registrar Main Agent Computershare Trust Company of Canada Street address: 1500 University Street Suite 700 Montreal, Quebec Canada H3A 3S8 Tel: (514) 982-7555, or 1-866-586-7635 Fax: (514) 982-7635 website: computershare.com Co-Transfer Agent (U.S.) The Bank of New York 101 Barclay Street New York, New York U.S. 10286 Co-Transfer Agent (United Kingdom) Computershare Services PLC Securities Services – Registrars P.O. Box No. 82, The Pavilions, Bridgwater Road, Bristol BS99 7NH England Stock exchange listings (Symbol: RY) Common shares are listed on: Canada Toronto Stock Exchange (TSX) U.S. New York Stock Exchange (NYSE) Switzerland Swiss Exchange (SWX) All preferred shares are listed on the Toronto Stock Exchange. Valuation Day price For capital gains purposes, the Valuation Day (December 22, 1971) cost base for our common shares is $7.38 per share. This amount has been adjusted to reflect the two-for-one share split of March 1981 and the two-for-one share split of February 1990. The one-for-one share dividend paid in October 2000 and April 2006 did not affect the Valuation Day value for our common shares. Shareholder contact For information about stock transfers, address changes, dividends, lost stock certificates, tax forms, estate transfers, contact: Computershare Trust Company of Canada 100 University Ave., 9th Floor Toronto, Ontario M5J 2Y1 Tel: (514) 982-7555 or 1-866-586-7635 For other shareholder inquiries, contact: Shareholder Services Royal Bank of Canada 123 Front Street West 6th Floor Toronto, Ontario Canada M5J 2M2 Tel: (416) 955-7806 or visit our website at rbc.com/investorrelations 2007 quarterly earnings release dates First quarter Second quarter Third quarter Fourth quarter March 2 May 25 August 24 November 30 Direct deposit service Shareholders in Canada and the U.S. may have their dividends deposited by electronic funds transfer. To arrange for this service, please contact Computershare Trust Company of Canada at their mailing address. Dividend Reinvestment Plan Our Dividend Reinvestment Plan provides our registered common shareholders residing in Canada and the United States with the means to purchase additional common shares through the automatic reinvestment of their cash dividends. For more information on participation in the Dividend Reinvestment Plan, please contact our Plan Agent: Computershare Trust Company of Canada Attn: Dividend Reinvestment Dept. 100 University Avenue, 9th Floor Toronto, Ontario M5J 2Y1 Tel: 1-866-586-7635 (Canada and U.S.) or (514) 982-7555 Fax: (416) 263-9394 or 1-888-453-0330 e-mail: service@computershare.com Institutional investors, brokers and security analysts For financial information inquiries, contact: Investor Relations Royal Bank of Canada 123 Front Street West 6th Floor Toronto, Ontario Canada M5J 2M2 Tel: (416) 955-7803 Fax: (416) 955-7800 Common share repurchases We are engaged in a normal course issuer bid through the facilities of the Toronto Stock Exchange. During the one-year period commencing November 1, 2006, we may repurchase up to 40 million shares in the open market at market prices. We determine the amount and timing of the purchases. A copy of our Notice of Intention to file a normal course issuer bid may be obtained, with- out charge, by contacting the Secretary of the bank at our Toronto mailing address. 2007 Annual Meeting The Annual Meeting of Common Shareholders will be held at 9:00 a.m. (EST) on Friday, March 2, 2007 at the Metro Toronto Convention Centre, North Building, 255 Front Street West, Toronto Ontario, Canada Dividend dates for 2007 Subject to approval by the Board of Directors Common and preferred shares series N, W, AA, AB and AC Record dates Payment dates January 25 April 25 July 26 October 25 February 23 May 24 August 24 November 23 Credit ratings (as at November 29, 2006) Short-term debt Senior long-term debt Moody’s Investors Service Standard & Poor’s Fitch Ratings Dominion Bond Rating Service P-1 A-1+ F1+ R-1(high) Aa2 AA AA AA La Banque Royale publie aussi son Rapport annuel en français. Legal Deposit, fourth quarter, 2006 Bibliothèque nationale du Québec Printed in Canada This annual report is printed on acid-free paper and the entire book is recyclable. Information contained in or otherwise accessible through the websites mentioned in this annual report does not form a part of this annual report. All references in this annual report to websites are inactive textual references and are for your information only. Trademarks used in this report include the LION & GLOBE Symbol, ROYAL BANK OF CANADA, RBC, RBC CANADIAN PERSONAL AND BUSINESS, RBC U.S. AND INTERNATIONAL PERSONAL AND BUSINESS, RBC CAPITAL MARKETS, RBC ASSET MANAGEMENT, RBC CAPITAL TRUST, RBC CENTURA, RBC DAIN RAUSCHER, RBC DIRECT INVESTING, RBC DOMINION SECURITIES, RBC INSURANCE, RBC MORTGAGE, RBC CASH FLOW PORTFOLIOS, RBC HEDGE 250 INDEX, RBC HOMELINE PLAN, RBC MANAGED PORTFOLIOS, RBC NO LIMIT ACCOUNT, RBC REWARDS and RBC TruCS, which are trademarks of Royal Bank of Canada used by Royal Bank of Canada and/or its subsidiaries under license. All other trademarks mentioned in this report, which are not the property of Royal Bank of Canada, are owned by their respective holders. RBC Dexia IS and affiliated Dexia companies are licensed users of the RBC trademark. d n a r b r e t n I Royal Bank of Canada Annual Report 2006 Shareholder information 165 Vision Values Strategic goals • Always earning the right to be • Excellent service to clients our clients’ first choice and each other • Working together to succeed • Personal responsibility for high performance • To be the undisputed leader in financial services in Canada • To build on our strengths in banking, wealth management and capital markets in the United States • Diversity for growth and • To be a premier provider innovation • Trust through integrity in everything we do of selected global financial services Financial highlights (C$ millions, except per share and percentage amounts) Operating performance Total revenue Provision for credit losses Non-interest expense Net income Return on common equity (ROE) Diluted earnings per share 2006 2005 2004 $ 20,637 429 11,495 4,728 23.5% 3.59 $ $ 19,184 455 11,357 3,387 18.0% 2.57 $ $ 17,802 346 10,833 2,803 15.6% 2.11 $ 2006 vs. 2005 Increase (decrease) $ $ 1,453 8% (26) (6)% 138 1% 1,341 40% 550 bps n.m. 1.02 40% RBC Canadian Personal and Business (C$ millions, except percentage amounts) Total revenue Net income Return on equity (ROE) Average loans and acceptances Average deposits Assets under administration Assets under management 2006 2005 2004 $ 13,381 $ 12,499 $ 11,213 2,043 24.7% 145,300 133,700 157,300 58,700 2,794 31.5% 180,500 145,700 213,200 89,700 2,304 27.1% 161,500 138,800 180,300 72,100 The businesses in RBC Canadian Personal and Business continued to strengthen our leadership position in most major product categories by expanding our distribution network, enhancing our products and services, better meeting our client needs and deepening our client relationships. 2006 vs. 2005 Increase (decrease) $ 882 7% 490 21% 440 bps n.m. 19,000 12% 6,900 5% 32,900 18% 17,600 24% 9.6% 11.9% $ 223,709 9.6% 13.1% $ 197,004 8.9% 12.4% $ 183,409 – bps n.m. (120)bps n.m. $ 26,705 14% RBC U.S. and International Personal and Business Capital Tier 1 capital ratio Total capital ratio Risk-adjusted assets Key drivers Total loans (before allowance for loan losses) Total deposits Total assets Assets under management Assets under administration (1) Common share information Share price High Low Close Dividends declared per share Book value per share Market capitalization ($ millions) $ 209,939 343,523 536,780 143,100 525,800 $ 191,914 306,860 469,521 118,800 417,100 $ 172,560 270,959 426,222 102,900 391,000 $ 18,025 9% 36,663 12% 67,259 14% 24,300 21% 108,700 26% $ 51.49 41.29 49.80 1.44 16.52 63,788 $ 43.34 30.45 41.67 1.18 14.89 53,894 $ 32.95 29.02 31.70 1.01 13.57 40,877 $ 8.15 19% 10.84 36% 8.13 20% .26 22% 1.63 11% 9,894 18% Excluding Institutional & Investor Services (IIS) assets that were contributed to the joint venture RBC Dexia Investor Services on January 2, 2006. (1) n.m. not meaningful (C$ millions, except percentage amounts) Total revenue Net income Return on equity (ROE) 2006 2005 2004 2006 vs. 2005 Increase (decrease) $ 2,872 $ 444 13.6% 2,728 $ 387 11.8% 2,702 $ 214 5.4% 144 5% 57 15% 180 bps n.m. (US$ millions, except percentage amounts) 2006 2005 2004 2006 vs. 2005 Increase (decrease) Total revenue Net income Average loans and acceptances Average deposits Assets under administration Assets under management $ 2,537 $ 393 18,300 29,700 274,200 47,500 2,248 $ 320 16,900 27,400 198,400 39,500 2,057 162 14,400 25,200 191,800 36,300 $ 289 13% 73 23% 1,400 8% 2,300 8% 75,800 38% 8,000 20% The wealth management and banking businesses in RBC U.S. and International Personal and Business continued to build scale and capabilities through a combination of organic growth initiatives and acquisitions. In 2006, we expanded our distri- bution network and products and services, and focused our expansion in fast-growing markets and regions. RBC Capital Markets (C$ millions, except percentage amounts) 2006 2005 2004 2006 vs. 2005 Increase (decrease) Total revenue (teb) (1) Net income Return on equity (ROE) Average loans and acceptances Average deposits $ 4,693 $ 1,407 29.3% 23,500 118,800 4,062 760 18.1% 17,600 98,900 $ 3,933 $ 827 19.5% 18,600 88,400 631 16% 647 85% 1,120 bps n.m. 5,900 34% 19,900 20% (1) Taxable equivalent basis (teb). By successfully executing growth plans, the businesses in RBC Capital Markets maintained our position as the undisputed leader in the Canadian market, and expanded our activities in the U.S. mid market and our global infrastructure finance platform. Shareholder information Corporate headquarters Street address: Royal Bank of Canada 200 Bay Street Toronto, Ontario, Canada Tel: (416) 974-5151 Fax: (416) 955-7800 Mailing address: P.O. Box 1 Royal Bank Plaza Toronto, Ontario Canada M5J 2J5 website: rbc.com Transfer Agent and Registrar Main Agent Computershare Trust Company of Canada Street address: 1500 University Street Suite 700 Montreal, Quebec Canada H3A 3S8 Tel: (514) 982-7555, or 1-866-586-7635 Fax: (514) 982-7635 website: computershare.com Co-Transfer Agent (U.S.) The Bank of New York 101 Barclay Street New York, New York U.S. 10286 Co-Transfer Agent (United Kingdom) Computershare Services PLC Securities Services – Registrars P.O. Box No. 82, The Pavilions, Bridgwater Road, Bristol BS99 7NH England Stock exchange listings (Symbol: RY) Common shares are listed on: Canada Toronto Stock Exchange (TSX) U.S. New York Stock Exchange (NYSE) Switzerland Swiss Exchange (SWX) All preferred shares are listed on the Toronto Stock Exchange. Valuation Day price For capital gains purposes, the Valuation Day (December 22, 1971) cost base for our common shares is $7.38 per share. This amount has been adjusted to reflect the two-for-one share split of March 1981 and the two-for-one share split of February 1990. The one-for-one share dividend paid in October 2000 and April 2006 did not affect the Valuation Day value for our common shares. Shareholder contact For information about stock transfers, address changes, dividends, lost stock certificates, tax forms, estate transfers, contact: Computershare Trust Company of Canada 100 University Ave., 9th Floor Toronto, Ontario M5J 2Y1 Tel: (514) 982-7555 or 1-866-586-7635 For other shareholder inquiries, contact: Shareholder Services Royal Bank of Canada 123 Front Street West 6th Floor Toronto, Ontario Canada M5J 2M2 Tel: (416) 955-7806 or visit our website at rbc.com/investorrelations 2007 quarterly earnings release dates First quarter Second quarter Third quarter Fourth quarter March 2 May 25 August 24 November 30 Direct deposit service Shareholders in Canada and the U.S. may have their dividends deposited by electronic funds transfer. To arrange for this service, please contact Computershare Trust Company of Canada at their mailing address. Dividend Reinvestment Plan Our Dividend Reinvestment Plan provides our registered common shareholders residing in Canada and the United States with the means to purchase additional common shares through the automatic reinvestment of their cash dividends. For more information on participation in the Dividend Reinvestment Plan, please contact our Plan Agent: Computershare Trust Company of Canada Attn: Dividend Reinvestment Dept. 100 University Avenue, 9th Floor Toronto, Ontario M5J 2Y1 Tel: 1-866-586-7635 (Canada and U.S.) or (514) 982-7555 Fax: (416) 263-9394 or 1-888-453-0330 e-mail: service@computershare.com Institutional investors, brokers and security analysts For financial information inquiries, contact: Investor Relations Royal Bank of Canada 123 Front Street West 6th Floor Toronto, Ontario Canada M5J 2M2 Tel: (416) 955-7803 Fax: (416) 955-7800 Common share repurchases We are engaged in a normal course issuer bid through the facilities of the Toronto Stock Exchange. During the one-year period commencing November 1, 2006, we may repurchase up to 40 million shares in the open market at market prices. We determine the amount and timing of the purchases. A copy of our Notice of Intention to file a normal course issuer bid may be obtained, with- out charge, by contacting the Secretary of the bank at our Toronto mailing address. 2007 Annual Meeting The Annual Meeting of Common Shareholders will be held at 9:00 a.m. (EST) on Friday, March 2, 2007 at the Metro Toronto Convention Centre, North Building, 255 Front Street West, Toronto Ontario, Canada Dividend dates for 2007 Subject to approval by the Board of Directors Common and preferred shares series N, W, AA, AB and AC Record dates Payment dates January 25 April 25 July 26 October 25 February 23 May 24 August 24 November 23 Credit ratings (as at November 29, 2006) Short-term debt Senior long-term debt Moody’s Investors Service Standard & Poor’s Fitch Ratings Dominion Bond Rating Service P-1 A-1+ F1+ R-1(high) Aa2 AA AA AA La Banque Royale publie aussi son Rapport annuel en français. Legal Deposit, fourth quarter, 2006 Bibliothèque nationale du Québec Printed in Canada This annual report is printed on acid-free paper and the entire book is recyclable. Information contained in or otherwise accessible through the websites mentioned in this annual report does not form a part of this annual report. All references in this annual report to websites are inactive textual references and are for your information only. Trademarks used in this report include the LION & GLOBE Symbol, ROYAL BANK OF CANADA, RBC, RBC CANADIAN PERSONAL AND BUSINESS, RBC U.S. AND INTERNATIONAL PERSONAL AND BUSINESS, RBC CAPITAL MARKETS, RBC ASSET MANAGEMENT, RBC CAPITAL TRUST, RBC CENTURA, RBC DAIN RAUSCHER, RBC DIRECT INVESTING, RBC DOMINION SECURITIES, RBC INSURANCE, RBC MORTGAGE, RBC CASH FLOW PORTFOLIOS, RBC HEDGE 250 INDEX, RBC HOMELINE PLAN, RBC MANAGED PORTFOLIOS, RBC NO LIMIT ACCOUNT, RBC REWARDS and RBC TruCS, which are trademarks of Royal Bank of Canada used by Royal Bank of Canada and/or its subsidiaries under license. All other trademarks mentioned in this report, which are not the property of Royal Bank of Canada, are owned by their respective holders. RBC Dexia IS and affiliated Dexia companies are licensed users of the RBC trademark. d n a r b r e t n I Royal Bank of Canada Annual Report 2006 Shareholder information 165 Total shareholder returns (TSR) (1) (on a $100 investment on November 1, 2001) Market capitalization (millions) C$ US$ 3 7 1 $ 4 4 1 $ 3 9 1 $ 8 4 1 $ 0 2 1 $ 2 2 1 $ 0 5 3 $ 7 4 2 $ 9 6 2 $ 1 0 2 $ , 8 8 7 3 6 $ , 4 9 8 3 5 $ , 4 4 6 1 4 $ , 7 7 8 0 4 $ , 7 9 1 6 3 $ 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Shareholder performance TSR () C$ 2006 vs. 2005 23% 30% Market capitalization • Largest Canadian bank • Largest Canadian company • 7th largest North American bank US$ 5-year CAGR (2) 20% 28% Diluted earnings per share Return on common equity Financial performance . 9 5 3 $ . 7 5 2 $ . 6 9 1 $ . 0 2 2 $ . 1 1 2 $ % 8 5 1 . % 7 6 1 . % 6 5 1 . % 0 8 1 . % 5 3 2 . Diluted EPS 2006 vs. 2005 40% 5-year CAGR (2) 5% 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Net income (millions) Total revenue (millions) 2 0 7 2 $ , 8 6 9 2 $ , 3 0 8 2 $ , 7 8 3 3 $ , 8 2 7 4 $ , , 2 9 0 7 1 $ , 8 8 9 6 1 $ , 2 0 8 7 1 $ , 4 8 1 9 1 $ , 7 3 6 0 2 $ 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Total loans (millions) , 3 7 7 7 6 1 $ , 9 4 4 2 6 1 $ , 0 6 5 2 7 1 $ , 9 3 9 9 0 2 $ , 4 1 9 1 9 1 $ Total deposits (millions) , 6 7 4 3 4 2 $ , 5 4 1 9 5 2 $ , 9 5 9 0 7 2 $ , 3 2 5 3 4 3 $ , 0 6 8 6 0 3 $ 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 Note: All data in Canadian dollars unless otherwise stated. () (2) TSR – Total shareholder return is price appreciation plus dividends reinvested, annualized. Five-year compound annual growth rate (CAGR). Financial performance Net income 2006 vs. 2005 40% 5-year CAGR (2) 5% Total revenue 8% 5% Key business drivers Total loans 2006 vs. 2005 9% 5-year CAGR (2) 5% Total deposits 2% 8% Royal Bank of Canada Annual Report 2006 Financial highlights Where our vision leads us Chief Executive Officer’s message Royal Bank of Canada Annual Report 2006 2 Chief Executive Officer’s message Royal Bank of Canada Group Executive (L to R): Elisabetta Bigsby, Group Head, Human Resources and Transformation; Martin J. Lippert, Group Head, Global Technology and Operations; Barbara G. Stymiest, Chief Operating Officer; Gordon M. Nixon, President and Chief Executive Officer; W. James Westlake, Group Head, RBC Canadian Personal and Business; Peter Armenio, Group Head, RBC U.S. and International Personal and Business; Charles M. Winograd, Group Head, RBC Capital Markets. Since 2004, “Always earning the right to be our clients’ first choice” has been our vision and guiding philosophy. We strongly believe we can continually do more for our clients, which drives us to keep improving the way we work with them and each other. Our vision has led us to find the best solutions for our clients. Our ongoing success has enabled us to keep delivering superior returns to our shareholders while funding new opportunities in our businesses. In 2006, we delivered record financial results and reached the significant milestone of earning more than $ billion each quarter. These results reflect the strong growth of all our businesses, our successful execution of growth initiatives, and favourable conditions in our domestic and international markets. During the year, we continued to return capital to our shareholders through dividend increases and share buybacks, delivering a total shareholder return of 23 per cent (30 per cent in U.S. dollars), for the year ended October 3. We paid a stock dividend, which had the same effect as a two-for-one split of our common shares, and made our shares accessible to more investors. Our strategic goals drive our success When we first articulated our Client First approach, all of us at RBC made a commitment to exceed client expectations at every oppor- tunity and through every service channel. We believe more clients will give us more of their business if we can consistently deliver on this promise. To do this, we focus on three strategic goals: . To be the undisputed leader in financial services in Canada. 2. To build on our strengths in banking, wealth management and capital markets in the United States. 3. To be a premier provider of selected global financial services. We have made progress on each of these goals through a variety of initiatives, each with the common objective of serving our clients to the best of our abilities. In Canada, we extended our leadership in most major product categories serving retail and wholesale clients. We are the top provider of major consumer lending products as a result of our strong market shares in personal loans, credit cards and residential mortgages. Strong product offerings combined with the scale, diversity and reach of our distribution network allowed RBC to become the fastest growing mutual fund company in the country. Our capital markets leadership in Canada has been recognized by many national and international sources. The size and diversity of our Canadian operations have also bene- fited our enterprise as a whole, contributing to a foundation for sustainable growth. The strength of our balance sheet supports solid credit ratings, and we were named the safest Canadian bank and fourth safest bank in North America (Global Finance magazine). Centralized operations and technology continue to enable economies of scale and foster the innovation required to strengthen and leverage our leadership position globally. And our brand was again recognized as the most valuable in Canada, an asset that we continually look to build upon globally. In reviewing progress towards our second goal, I am pleased with the growth across all our businesses in the U.S. This year, our U.S. banking operations delivered improved results, based on a clear strategy of serving businesses, business owners and professionals while investing in infrastructure that will support future growth. This year, we announced an agreement to complete two acquisitions that are excellent strategic, economic and cultural fits with our operations in the Southeast U.S. The acquisition of Flag Financial Corporation, which operates the largest community bank headquartered in Atlanta, will increase our client reach in a key growth market. Also, our November 2006 announcement to acquire 39 branches in Alabama owned by AmSouth Bancorporation will immediately make us the seventh largest financial institution in that state, as measured by deposits. Both acquisitions, expected to close in early 2007, complement our de novo branch openings in high-growth areas. Close linkages across our businesses allow us to use our capital markets capabilities to better serve U.S. retail investors by pro viding them access to global debt origination and structured product capabilities. We continued this year to build scale and capability to serve these clients, opening 0 new wealth manage- ment offices in high-growth cities and recruiting productive and successful financial consultants from our competition. And, as a result of our acquisition of Delaware-based American Guaranty & Trust Company, we are able to more effectively provide U.S. trust solutions to high net worth clients. Our U.S. investment banking and fixed income capabilities are expanding due to a combination of organic growth and acquisi- tions that have brought us closer to our goal of being a top-tier provider to U.S. middle-market companies. We were ranked among the top investment banks targeting the U.S. middle market, and through the first three calendar quarters of 2006, we ranked first for number of issues as senior manager in the Royal Bank of Canada Annual Report 2006 Chief Executive Officer’s message 3 municipal finance market (Thomson Financial). Late in the fiscal year, we announced an agreement to acquire the broker-dealer business and certain assets of Carlin Financial Group of New York, which will provide our clients with a best-in-class North American electronic execution platform. Finally, in November 2006, we announced an agreement to acquire Daniels & Associates L.P., the most active mergers and acquisitions advisor in the U.S. to the cable, telecom and broadcast industries. Both the Carlin and Daniels transactions are expected to close in early 2007. To achieve our third goal we invested in several global businesses where we can leverage our competitive strengths to enable us to meet our clients’ increasing needs. For example, we expanded our infrastructure finance capabilities and now have a successful global infrastructure finance platform with offices in North America, Europe and Australia. We strengthened our ability to serve wealth management clients when we acquired Abacus Financial Services Group, a transaction that made RBC the top provider of international trust services in the U.K. (Euromoney magazine). In 2006, we also recognized the growing importance of China to our global business and made a number of investments to help us unlock opportunities available in this important growth market. As we have done successfully in other parts of the world, we are making targeted investments in areas where we have global competitive advantages. Building on our historical pres- ence in China, we upgraded our representative banking office in Beijing to branch status, enabling us to provide a greater range of services to institutional and individual clients. Our global capital markets depth is evident through our role as a co-lead manager of the institutional tranche for the Industrial and Commercial Bank of China’s initial public offering. A more detailed discussion of what we have achieved on these three goals and what we plan to do in 2007 and beyond is provided on pages 6 to 2. Our record results I am pleased that we have met our medium-term objective of delivering top quartile total shareholder returns. While we deliv- ered a total shareholder return of 23 per cent (30 per cent in U.S. dollars), for the year ended October 3, our 5- and 0-year total shareholder returns of 20 per cent (28 per cent in U.S. dollars) and 20 per cent (22 per cent in U.S. dollars), respectively, rank among the highest of all global banks. Our net income reached $4.7 billion, up 40 per cent from 2005, and our return on equity was 23.5 per cent, which are impressive results for any financial institution. We met or exceeded all but one of our financial objectives for 2006. Our diluted EPS growth, ROE, revenue growth and dividend payout ratio all met the targets we set for the year, and we exceeded our portfolio quality objective, which was supported by a favourable credit environ- ment. Our solid capital position was maintained comfortably above our objective. We raised our dividends twice in 2006 by a total of $.26 per share, or 22 per cent. (Excluding the impact of the Enron Corp. litigation-related provision in 2005, net income and diluted EPS both increased 27 per cent.) Royal Bank of Canada Annual Report 2006 4 Chief Executive Officer’s message While we performed well against these measures, we did not meet our target for operating leverage as it was impacted by our business mix and certain factors which contributed to our earnings growth but were not appropriately captured in this measure. As noted below, and in more detail on page 32, we have adjusted our 2007 operating leverage calculation to take those factors into account to more accurately reflect the underlying performance of our businesses going forward. How we will measure ourselves in 2007 Looking ahead, we remain committed to generating top quartile total shareholder returns in relation to our Canadian and U.S. peer group over the medium term. On page 5, we show our 2007 financial objectives to meet this medium-term objective. These objectives are based on our expectation of a robust Canadian economy with continuing strong consumer spending and solid business investment. In the U.S., we expect a moderately slower economy, largely attributable to slightly weaker growth in consumer spending and a cooling housing market. We expect to continue to benefit from relatively favourable equity markets, a stable interest rate environment, and strong fiscal conditions. Our 2007 objectives are focused on measures that we believe are required to generate strong returns for our shareholders. Our ROE, Tier capital and dividend ratios remain unchanged. For 2007, our objective of growing our diluted EPS by at least 0 per cent is lower than the 2006 objective as our 2005 earnings included the impact of the provisions related to the Enron litigation and estimated net claims related to hurricanes Katrina, Rita and Wilma. Our operating leverage objective remains greater than three per cent, however, we have adjusted our operating leverage calculation to more appropriately reflect the performance of our businesses. Our revenue growth target is incorporated in our earnings per share and adjusted operating leverage objectives. In addition, we believe our portfolio quality is adequately captured in our profitability and other objectives. Our success depends on our employees putting clients first This has been an exciting year of growth for RBC. Our record performance in 2006 reflects the talent and commitment of all our employees. Their hard work has resulted in our clients rewarding us with more of their business and, most importantly, their trust. We remain committed to developing new and innovative ways to meet our clients’ needs while achieving our strategic goals and continuing to provide superior returns for our shareholders. I would like to sincerely thank our clients for their continued busi- ness and our employees around the world for their dedication to finding new ways to earn the right to be our clients’ first choice. Gordon M. Nixon President and Chief Executive Officer 2006 performance review The table below shows our 2006 performance compared to our objectives for the year. . Diluted earnings per share (EPS) growth 2. Return on common equity (ROE) 3. Revenue growth 4. Operating leverage 5. Portfolio quality (4) 6. Capital management: Tier capital ratio (5) 7. Dividend payout ratio 2006 Objectives () 2006 Performance 20%+ (2) 20%+ 6–8% >3% (3) .40–.50% 8%+ 40–50% 40% (6) 23.5% 8% % (7) .23% 9.6% 40% () (2) (3) Our 2006 financial objectives were established late in fiscal 2005 and reflected our economic and business outlooks for 2006. We established aggressive objectives for 2006 to position us as a top quartile performer with respect to total return to shareholders relative to our Canadian and U.S. peers. At the time these objectives were established, we expected an average Canadian dollar value of US$.87 in 2006; however, the actual dollar value was US$.883. Based on 2005 total reported diluted EPS of $5.3, which has been retroactively adjusted to $2.57 to reflect a stock dividend of one common share on each of our issued and outstanding common shares, paid on April 6, 2006. Operating leverage is the difference between revenue growth rate and non-interest expense growth rate. Our 2006 objective is based on 2005 non-interest expenses excluding the Enron litigation provision of $59 million recorded in Q4 2005. Ratio of specific provisions for credit losses to average loans and acceptances. Calculated using guidelines issued by the Office of the Superintendent of Financial Institutions Canada (OSFI). Excluding the impact of the Enron Corp. litigation-related provision in 2005, diluted EPS increased 27%. (4) (5) (6) (7) We have adjusted our 2007 operating leverage calculation to incorporate certain factors in order to more appropriately reflect the performance of our businesses going forward. If this new approach was applied to our 2006 results, our adjusted operating leverage would have been 2.5%. Adjusted operating leverage is a non-GAAP financial measure. For a further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section in the Management’s Discussion and Analysis (MD&A). 2007 objectives . Diluted earnings per share (EPS) growth 2. Adjusted operating leverage () 3. Return on common equity (ROE) 4. Tier capital ratio (2) 5. Dividend payout ratio Objectives 0%+ >3% 20%+ 8%+ 40–50% () (2) Adjusted operating leverage is the difference between revenue growth rate (as adjusted) and non-interest expense growth rate (as adjusted). Revenue is based on a taxable equivalent basis, excluding consolidated variable interest entities (VIEs), accounting adjustments related to the new Financial Instruments Standard and insurance-related revenue, while non-interest expense excludes insurance-related expense. For further details, see Key financial measures (non-GAAP) section in the MD&A. Calculated using guidelines issued by the OSFI. Medium-term objective . Total shareholder return () Top quartile (2) Top quartile (2) Objective 2006 Performance () (2) Total shareholder return is calculated based on share price appreciation plus reinvested dividend income. Versus seven large Canadian financial institutions (Manulife Financial Corporation, Bank of Nova Scotia, TD Bank Financial Group, BMO Financial Group, Sun Life Financial Inc., Canadian Imperial Bank of Commerce and National Bank of Canada) and 3 U.S. financial institutions (Bank of America, JP Morgan Chase & Co., Wells Fargo & Company, Wachovia Corporation, US Bancorp, Sun Trust Banks, Inc., The Bank of New York, BB&T Corporation, Fifth Third Bancorp, National City Corporation, The PNC Financial Services Group, KeyCorp and Northern Trust Corporation). Royal Bank of Canada Annual Report 2006 Performance compared to objectives 5 Where more Canadian clients put their trust for all their financial solutions STRATEGIC GOAL Operations in Canada Strengths and capabilities WHERE WE ARE To be the undisputed leader in financial services in Canada We provide personal, commer- cial, corporate and investment banking, wealth manage ment and insurance to over 3 mil - lion personal, business and public sector clients across Canada. We are the premier marketer and distributor of financial products and services. We offer private banking services and expertise to individuals, corporations, institutions and internationally based high net worth clients who have family or business interests in Canada. We lead in the Canadian wholesale banking market, supporting corporate, public and insti- tutional clients with strategic advice and financing solu- tions, including investment banking, research, sales and trading. Canadians seek financial advice and solutions from RBC to achieve their individual goals. Our scale and diverse businesses provide the opportunity to offer competi- tive, flexible and innovative products and services to new and existing clients. We have one of the most recognized and most valuable brands in the country. In most parts of Canada, we hold strong market positions in all our businesses, including top rankings in personal and busi- ness banking, wealth manage- ment, wholesale banking and creditor and travel insurance. Our clients benefit from the insight, dedication and exper- tise of our more than 40,000 employees, our broad suite of integrated products and services and our approach to developing strong relation- ships. Clients can access our financial offerings through our leading distribution capability, which includes a network of ,7 branches, the country’s largest number of automated banking machines (ABMs), online and telephone banking, Canada’s largest mortgage specialist sales force, as well as through a large number of investment advisors and a large force of third-party inde- pendent insurance distributors. We are the only Canadian wholesale bank with a global fixed income distribution capability for issuing clients. Our clients have access to key global markets through our full suite of debt, equity, advisory and alternative asset capabilities. We continue to enhance our geographic reach and product capabilities to meet the expanding needs of our clients. Royal Bank of Canada Annual Report 2006 6 To be the undisputed leader in financial services in Canada KEY HIGHLIGHTS • Most valuable brand in Canada with a value of $3.99 billion in the first annual Best Brands in Canada ranking (Interbrand). • Largest bank-owned sales force, branch network, ABM network, full service brokerage, bank- owned insurer and stand-alone mutual fund company (by assets under management) in Canada. • The leading wholesale bank in Canada in most of our lines of business (Thomson Financial, Bloomberg and Financial Post). Achievements in 2006 WHERE WE ARE GOING 2007 and beyond Banking Wealth management Capital markets • Continue to attract new • Expanded and refurbished our branch network and restruc- tured our retail sales organiza- tion to improve distribution capabilities, client delivery and enhance client experiences. • Redesigned our secured home equity product, RBC Homeline Plan, to better meet client needs by enhancing flexibility while improving delivery. • Introduced the RBC No Limit Account, a high-volume transaction account providing significant savings for clients who rely upon the convenience of debit cards for everyday transactions. • Launched our Welcome to Canada online program to attract, grow and retain clients who are new immigrants and/or part of Canada’s high growth South Asian and Chinese communities. • Launched a charitable gift pro gram to provide a tax-efficient and convenient way for individuals to create a lasting legacy. • Introduced a new commission rate structure for self-directed investors, including lower fees for active traders as part of an aggressive strategy to provide self-directed investors with more compelling value and convenience. • Introduced specialized products to support the retiring boomer market in Canada, including RBC Cash Flow Portfolios and RBC Managed Portfolios. • Named Dealmaker of the Year (Financial Post), remained the market leader in M&A and fixed income and held the leading market share of the fast-growing Maple market, where foreign institutions issue Canadian dollar bonds (Thomson Financial and Bloomberg). • Played key roles in Canada’s largest transactions, including the initial public offering of Tim Hortons, the acquisitions of Inco Limited by Companhia Vale do Rio Doce and Dofasco Inc. by Arcelor S.A. Insurance • Continued to provide clients with easier access to and more choice of products and services by launching the first nationwide online quote and purchase capability for home and auto insurance in Canada. • Named Favourite Travel Insurance Provider by Canadian travel agents for fourth consecutive year (Canadian Travel Press). personal and business clients and deepen existing relationships. • Emphasize profitable growth in high value retail markets. • Focus on delivering advice and service excellence to our personal and business clients, enhance our productivity and local market competitiveness. • Build upon our traditional strengths in distribution, product breadth, client relationship management, integration and risk manage- ment to enable the success of our personal and business clients. • Create new and stronger relationships with Canada’s middle-market companies. • Continue to be a leader in providing corporate and institutional clients with the full breadth of RBC Capital Markets’ global capabilities. Royal Bank of Canada Annual Report 2006 To be the undisputed leader in financial services in Canada 7 Where a growing number of U.S. clients succeed using our focused and increasingly integrated strengths STRATEGIC GOAL Operations in the U.S. WHERE WE ARE To build on our strengths in banking, wealth management and capital markets in the United States We are focused on serving an increasing number of individual and commercial clients in banking and wealth management and on becoming a significant wholesale bank to the U.S. mid market. We provide personal and business banking solutions to individuals, businesses, busi- ness owners and professionals through our regional banking network in the Southeast. Our ,680 financial consul- tants offer full-service wealth management expertise and customized financial services to 30,000 households in 40 states. We provide clearing and execution services to independent broker-dealers and institutions and also offer insurance protection and asset accumulation solutions nationwide. of capital markets services across seven industry sectors in major cities through out the U.S. Corporate, public and institutional clients of all sizes have access to our global debt origination and distribution capabilities as well as public and infrastructure finance. Strengths and capabilities All our U.S. clients benefit from the global resources of RBC, while drawing upon the knowledge and expertise of our employees who are dedi- cated to consistently deliver quality financial solutions and services. Importantly, strong and complementary linkages between our U.S. capital markets businesses and our retail operations allow us to leverage our extensive retail network to effectively distribute fixed income and structured products. We offer emerging and middle- market companies a full suite Our individual and busi- ness clients benefit from our Royal Bank of Canada Annual Report 2006 8 To build on our strengths in banking, wealth management and capital markets in the United States targeted approach. Our U.S. bank focuses on serving busi- nesses, business owners and professionals. We take the time to know our clients and differ- entiate ourselves, in a highly competitive marketplace, by tailoring financial products and services to meet their specific needs. Individual investors and businesses are well-served by our ability to tailor wealth management solutions devel- oped through long-lasting relationships with experienced financial consultants. Our U.S. middle-market corporate and institutional clients have access to a full suite of products and services focused on supporting their growth and financing strategies. We have established strength in municipal finance, and our global capabilities in securitization, infrastructure finance and public finance are helping to build our presence in this key market. KEY HIGHLIGHTS • Ranked eighth largest full-service • Ranked among top investment • Ranked number one for Senior securities firm in the U.S. as measured by number of financial consultants. • Opened 0 de novo banking branches to expand our presence and client reach in fast-growing southeastern markets. banks targeting the middle-market – 6th in initial public offerings and 4th in the equity league tables (Dealogic). Manager: Small Issues in the first three quarters of calendar 2006 for municipal finance (Thomson Financial). Achievements in 2006 Banking • Announced agreements to acquire Atlanta-based Flag Financial Corporation (Flag) along with its 7 branches and, in November 2006, 39 branches in Alabama owned by AmSouth Bank, providing us with a total of 338 branches in the Southeast once the transactions close. The transactions are subject to regulatory approvals and other customary conditions and are expected to close in the first quarter and second quarter of 2007, respectively. • Increased new personal accounts by 37 per cent and new business accounts by 20 per cent following the launch, in the first quarter of 2006, of a new streamlined suite of personal and business chequing accounts with unique features to better meet our clients’ needs. Wealth management • Achieved a record US$32 billion in assets under administration, up 4 per cent over 2005, by recruiting experienced financial consultants and executing our strategy to become the primary advisor to more of our retail investor clients by better understanding and meeting their needs. Capital markets • Selected to advise on one of the first Florida public/private partnerships. • Tripled distribution of structured notes through our wealth management network. • Announced agreement to acquire the broker-dealer busi- ness and certain other assets of Carlin Financial Group, based in New York, providing a best-in-class North American electronic execution platform. In addition, in November 2006, we announced an agreement to acquire Daniels & Associates L.P., the most active M&A advisor in the U.S. to cable, telecom and broadcast industries. Both transactions are subject to regulatory approvals and other customary conditions and are expected to close in the first quarter of 2007. • Achieved strong growth in our clearing and execution services business with 60 correspon- dent firms generating total assets under administration of US$34 billion, up 27 per cent from 2005. • Acquired American Guaranty & Trust Company, a Delaware- based trust business, enabling us to provide U.S. trust solu- tions to high net worth clients. Insurance • Achieved record sales in U.S. term life insurance business: 63 per cent year-over-year growth. • Expanded proprietary sales distribution in Florida to increase sales capability within our retail banking footprint. WHERE WE ARE GOING 2007 and beyond • Continue to focus on becoming the bank for businesses, busi- ness owners and professionals in the Southeast by expanding our products and services to meet the needs of this growing business segment. • Become the wealth manage- ment advisor of first choice to more clients by demonstrating overall strength in credit and lending, trust services and delivery of structured products and alternative investments. • Continue to expand our U.S. insurance capabilities through enhanced products and services. • Increase our investment banking client base by leveraging our broad product platform, advisory capabilities and global debt distribution. • Continue to expand relation- ships in the municipal finance market and establish ourselves as a key player in infrastructure finance. Royal Bank of Canada Annual Report 2006 To build on our strengths in banking, wealth management and capital markets in the United States 9 Where clients around the world obtain specialized products and trusted services STRATEGIC GOAL Operations around the world Strengths and capabilities WHERE WE ARE To be a premier provider of selected global financial services We provide investment banking, advisory and trading services, trade finance and reinsurance to corporate and institutional clients through offices worldwide. Our global debt business provides issuers with origination, securitization, structured products, infrastructure and project finance capabilities globally. Our wealth manage- ment offering is focused on providing expertise to high net worth individuals, and corpo- rate and institutional clients in 33 offices in 2 countries. We also provide banking solutions to individuals and businesses in the Caribbean. Our joint venture, RBC Dexia Investor Services (IS), offers a complete range of investor services, such as custody and fund administration, to institu- tions worldwide. Clients around the world seek sophisticated financial solutions and advice from us in selected global financial services markets. We leverage our regional and corporate strengths globally to keep pace with the expanding needs of our corporate and institu- tional clients and to support our strategic goals. We are recognized as a world leader in Canadian dollar trading and in Canadian dollar debt issuance and investor services. We provide global debt distri- bution and global capabilities in the mining and energy sectors, structured products, syndicated and infrastructure finance, and foreign exchange. Our global private bank ranks in the top 20 private banks worldwide based on market leadership by region and areas of service. Our financial professionals consistently deliver high quality wealth management solutions and advice to our clients. We have deep historical and community roots as a leading provider of a broad range of banking products and services in the Caribbean for more than 00 years. One of the world’s top 0 global custodians, RBC Dexia IS offers institutional investors worldwide an integrated suite of products, including global custody, fund and pension administration, securities lending, shareholder services, investment analytics and other related services. Royal Bank of Canada Annual Report 2006 0 To be a premier provider of selected global financial services KEY HIGHLIGHTS • Ranked as the top foreign exchange bank globally in Canadian dollar trading (Euromoney magazine). • Recognized as one of the top 20 private banks in the world (Euromoney magazine). • Added more than 0 client • Ranked in the top three in deposit facing employees around the world in wealth management. market share in most of our Caribbean banking markets. • Completed the creation of RBC Dexia IS, resulting in a top-tier global custodian with approxi- mately $.9 trillion in client assets under administration. Achievements in 2006 Capital markets Banking • Awarded Nomad status on the Alternative Investment Market, enabling us to bring junior mining and energy companies to the international market. • Enhanced sales management practices, improved client satisfaction and opened two new offices in The Bahamas, contributing to strong revenue growth across the Caribbean. Investments in China • Built on our historical presence in China when we upgraded our representative banking office to branch status and made targeted invest- ments in businesses where we have global competitive advantages including fund management, global debt markets, global financial insti- tutions and private banking. • Co-lead managed the institutional tranche for the Industrial and Commercial Bank of China’s initial public offering. • Established a global infrastruc- ture finance platform, with offices in Canada, U.S., Europe and Australia with marquee transactions, including lead advisor on a €.2 billion new rail project in France. Wealth management • Acquired Abacus Financial Services Group, adding 49 client facing professionals, expanding our client base and wealth management services in the U.K. and Channel Islands, and increasing assets under administration by US$4 bil lion. • Expanded lending solutions to meet the needs of our high net worth clients, increasing credit by 25 per cent. Also, launched a Canadian real estate invest- ment fund to allow interna- tional investors to participate in the Canadian commercial real estate sector. WHERE WE ARE GOING 2007 and beyond • Enhance our global capabilities in U.S. dollars and euros to complement our leading positions in Canadian dollars, British pounds, and New Zealand and Australian dollar origination. • Leverage our global distribu- tion platform to sell structured products in key Asian markets. • Expand our infrastructure finance expertise further into the U.S., Europe and Australia. • Expand market share among high net worth individuals by strengthening and building relationships with centres of influence who understand our value proposition and appreciate our commitment to delivering high-quality, customized solutions. • Build on our current strong position in Caribbean banking through organic growth and operational improvements. • Continue to expand oppor- tunistically in China where we have demonstrated global competitive advantages. Royal Bank of Canada Annual Report 2006 To be a premier provider of selected global financial services Where we support business growth, client focus and strong corporate governance Global Technology and Operations and Global Functions Team profile More than 8,000 employees in Global Technology and Operations (GTO) and Global Functions apply leading prac- tices to sup port RBC’s delivery of innovative ways to meet the changing needs and expecta- tions of our clients, employees and other stakeholders. In addition, GTO and Global Functions help RBC realize cost savings, allocate resources and strengthen governance. GTO provides the operational and technological foundation required for effective delivery of products and services to our clients. In partnership with the businesses and through its processing and call centres, GTO provides contact manage- ment, product fulfillment, sales, service, technology and operational support solutions that provide value to our clients. strong credit quality and lower ing our effective income tax rate. Global Functions is a team of specialized professionals that provides sound governance, thought leadership and an enterprise perspective on strategic issues, challenges and opportunities facing RBC and its businesses. It supports business growth by providing insight and governance in the areas of risk and controls, compliance, law, finance, tax, communications and brand. As well, it prudently manages the capital, liquidity and funding positions of the enterprise to ensure RBC meets regulatory requirements while ensuring effective cost management and capital allocation. Achievements in 2006 • Global Functions contributed to RBC’s financial performance and achievement of a number of objectives by effectively man aging capital, supporting the businesses in maintaining • Global Functions supported enter prise M&A activity by conducting comprehensive due diligence, negotiations and stakeholder relations in all major transactions, including the formation of RBC Dexia IS, the acquisitions of Abacus Financial Services Group Ltd., American Guaranty & Trust Company and the announced agreements to acquire Flag and the AmSouth branches. • GTO worked with its business partners to handle more than 00 million client calls, 330 million ABM transactions, 05 million online banking transactions, 2.3 billion point- of-sale transactions, and 00 million equity transactions. • RBC was named among the best companies globally for technology and organizational excellence for the seventh time in the past 0 years (CIO magazine). Royal Bank of Canada Annual Report 2006 2 Global Technology and Operations and Global Functions 2007 and beyond • GTO will focus on driving inno- vative process and technology improvements that simultane- ously deliver a differentiated client experience and increased operating leverage. • Global Functions will focus on contributing to our financial performance by continuing to maintain a solid balance sheet, strong credit quality and capital ratios, and effectively managing RBC’s tax position. • Global Functions will focus on contributing to business growth through maintaining a strong governance regime, an effec- tive brand strategy, strategic enterprise planning, proactive enterprise compliance, and solid relationships with investors, credit rating agencies, regulators and other stakeholders. • Global Functions and GTO will continue to partner with our businesses to improve and simplify processes that impact clients and employees. Where a foundation of good governance guides us Chairman’s message As stewards of the organiza- tion, we believe the foremost purpose of the Board of Directors is to create an environment for management that demands integrity while promoting long-term share- holder value. Good governance, which enables the creation and enhancement of shareholder value, is as important to the success of RBC as the operational achievements of the company. We are committed to the continuous improvement of our leading corporate governance practices. My goal as Chairman is to provide leadership to the board so it can continue to provide management with sound and independent advice. In 2006, our approach to corporate governance continued to receive recognition from our peers. In an annual ranking by chief executive officers of Canada’s major compa- nies, RBC was again named Most Respected Canadian Corporation, placing first in the category of Corporate Governance for the fourth consecutive year. We are key advisors to manage- ment in the development of strategy. Every board meeting over the past year included presentations on aspects of RBC’s strategy, taking into account the opportunities and risks of the businesses. We participated with manage- ment in an annual session dedicated to strategic planning and approved the enterprise strategy. In supervising management’s implementation of strategy, we approved major transactions and capital expenditures that were aligned with the strategic plan and regularly reviewed corporate performance against objectives. Our ability to contribute from a diversity of thought and back- grounds enhances the value we provide to RBC management and shareholders. The Corporate Governance and Public Policy Committee regularly reviews and assesses the board’s existing strengths and the evolving needs of the organization. We are pleased to welcome our newest directors whose experience will add an important dimension to the board. Timothy Hearn, Alice Laberge and Michael McCain are all well-recognized in their respective fields, and we are already benefiting from the contributions they are making to our discussions based on their experience in the Canadian and international business markets. To fulfill our responsibilities to you, our shareholders, we must have the expertise to make knowledgeable decisions concerning RBC’s global businesses in a rapidly evolving regulatory and business envi- ronment. As part of our ongoing director education program, we participated over the past year in sessions on specialized and complex aspects of RBC’s business operations, the implica- tions of the Basel II Capital Accord for RBC’s capital management framework, methodologies used in assessing risk, and the impact of new standards on financial statements and disclosure controls and certifications. I am pleased that the board has been able to contribute to the success of RBC in 2006. Further details of the governance prin- ciples and practices of the Board of Directors and RBC are available in the following pages and on our website at rbc.com/governance. On behalf of the Board of Directors, I extend appreciation to management and all 69,480 employees around the world for their contribution to RBC’s strong performance over the past year and their commitment to meeting our clients’ highest expectations. David P. O’Brien Chairman of the Board Royal Bank of Canada Annual Report 2006 Chairman’s message 3 “ Good governance, which enables the creation and enhancement of shareholder value, is as important to the success of RBC as the operational achievements of the company.” David P. O’Brien, Chairman of the Board Corporate governance Beyond compliance Our practices and policies fully comply with guidelines estab- lished by Canadian securities regulators as well as appli- cable provisions of the U.S. Sarbanes-Oxley Act of 2002 and requirements adopted by the New York Stock Exchange and the U.S. Securities and Exchange Commission. Strategically, our governance approach is to look beyond regulatory compliance with a view to building on our strong governance fundamentals by implementing best practices in support of the goals of the organization. In these pages we summarize some of the steps taken in recent years to achieve leading standards of corporate governance. A more complete description of RBC’s corporate governance practices may be found in our Management Proxy Circular and on our web site at rbc.com/governance. Building on our tradition of excellence Over the past few years, RBC has adopted many significant leading governance practices, including: • New rules requiring directors to tender their resignations following the Annual Meeting if they fail to receive majority shareholder support • Increased minimum share ownership guideline for direc- tors to $500,000 from the previous level of $300,000, to strengthen alignment of their interests with those of share- holders • Increased minimum share ownership requirements for top executives, with the CEO’s minimum threshold rising from six times to seven times average base salary, to further align management and share- holder interests • A requirement for senior executives to retain for at least one year Royal Bank common shares with a value equal to the after-tax gain realized on the exercise of options, so as to increase the alignment of their interests with those of shareholders • A Performance Deferred Share Program to strengthen the alignment of the interests of management with share- holders by tying senior management’s rewards to the performance of RBC relative to a peer group of competing North American financial institutions • Diminished share dilution resulting from the reduction of the number of stock option grants awarded to manage- ment by approximately 70 per cent since 2003. Royal Bank of Canada Annual Report 2006 4 Corporate governance • The Audit, Human Resources and Corporate Governance and Public Policy committees have sole authority to retain and approve the fees of inde- pendent, external advisors. The Human Resources Committee retains an indepen- dent compensation consultant • Board and director evaluation procedures have been enhanced, with written peer reviews added to complement the established peer assess- ment practice of one-on-one interviews with the Chairman • The process of selecting individuals for nomination as directors has been formalized to ensure that the strengths of potential candidates are weighed against the compe- tencies and skills that the board as a whole should possess. In addition: • Our comprehensive Director Independence Policy has continued to evolve in response to best practices and regulatory refinements. Under this policy, 4 of the 7 currently serving directors are independent • Meetings of independent directors are held regularly • All members of the board’s Audit Committee, Human Resources Committee, and Corporate Governance and Public Policy Committee are independent, and a majority of members of the Conduct Review and Risk Policy Committee are independent • For the Audit Committee, more stringent independence criteria have been imple- mented, a financial expert has been designated, financial literacy requirements have been defined and a policy limiting the service of our Audit Committee members on the audit committees of other companies has been approved Demonstrating leadership These measures build on our previous governance initia- tives, which include, among many others: • Ensuring independent leader- ship of the Board of Directors by being first among our peer companies to separate the positions of Chairman and Chief Executive Officer in 200 • Adopting a policy limiting interlocking directorships of board members • Discontinuing grants under the Director Stock Option Plan in 2002 • Being among the first major Canadian companies to expense stock options in financial statements, which we have done since 2003 • Providing continuous educa- tional material, presentations and programs to directors so they remain knowledgeable and informed about the ever-changing business and regulatory environment and the specialized and complex aspects of finance and our business operations. Royal Bank of Canada Annual Report 2006 Corporate governance 5 2007 Annual Meeting Shareholders are invited to attend our Annual Meeting at 9 a.m. (Eastern Standard Time) on Friday, March 2, 2007, at the Metro Toronto Convention Centre, North Building, 255 Front Street West, Toronto, or to listen to a webcast of the event. Further details will be made available on our investor relations website at rbc.com/ investorrelations/conference. Enhancing our disclosure In keeping with our goals of continuously improving gover- nance and providing greater transparency and simplicity in our communications, in recent years we have enhanced disclosure in our Management Proxy Circular, including: • More detail on the compensa- tion paid to individual directors and their share ownership • Greater clarity on senior offi- cers’ compensation relative to fiscal year performance • Three-year, easy-to-read overviews of senior officers’ compensation • Total aggregate compensation of the top management team as a percentage of market capitalization and a percent- age of net income after tax • Increased disclosure regarding executive pensions, including the impact of changes in interest rates, annual service cost, accrued obligation and value of retirement plans for top executives. Important information about our governance practices The following additional information on our governance practices is available at rbc.com/governance: • Our Statement of Corporate Governance Practices and Guidelines • Our Code of Conduct • The charters of our Board of Directors and each of its committees • Our Director Independence Policy • Position descriptions for the Chairman of the Board, the chairs of committees of the board, and the President and Chief Executive Officer • A summary of significant differences between the NYSE rules and our governance practices • Our Corporate Responsibility Report. Royal Bank of Canada Annual Report 2006 6 Corporate governance Where we make an impact Corporate responsibility At RBC, we define corporate responsibility as operating with integrity at all times and sustaining our long-term viability while contributing to the present and future well- being of our stakeholders. This means that we strive to take active responsibility for the daily choices that we face, especially in regard to ethical business practices, our economic impact, as well as our practices in the workplace, the environment and the community. Sustainability reporting Increasingly, companies are being asked to report on their social, environmental and ethical performance, which is sometimes called sustain- ability reporting. While there are many stakeholders asking for such information, there is little agreement about what and how much companies should disclose, as well as the appropriate manner of disclosure. RBC has adopted a multi- pronged approach to sustain- ability reporting. We provide tailored reporting geared to various stakeholders, with an appropriate level of detail in each. Additional information can be found on our website at rbc.com/responsibility. Royal Bank of Canada Annual Report 2006 Corporate responsibility 7 Corporate responsibility principles Business practices Economic impact • Comply with laws and • Provide strong returns to regulations • Manage under strong governance • Operate with ethical business practices • Provide products and access to banking services responsibly • Protect and educate consumers shareholders • Pay fair share of taxes • Support small business and community economic development • Foster innovation and entrepreneurship • Purchase goods and services responsibly Workplace and employment Environment Community • Respect diversity • Foster a culture of employee • Lend responsibly • Leverage “green” business engagement • Provide competitive compensation and total rewards • Provide opportunities for training and development opportunities • Reduce operational footprint • Provide donations with a lasting social impact • Sponsor key community initiatives • Enable employees to contribute At RBC, one of our key values is to operate with trust through integrity in everything we do. We have enterprise- wide compliance policies and processes to support the assessment and management of risks, and have formal poli- cies to address issues such as: • Economic sanctions • Lending to political parties • Financing military materiel • Money laundering • Terrorist financing • Conflicts of interest including outside activities and external directorships of employees Code of Conduct All RBC employees worldwide are governed by our Code of Conduct, which was estab- lished more than 20 years ago and is updated regularly. Our Code of Conduct e-learning program ensures all our employees (from the CEO down) know and understand the Code’s principles and compliance elements. This e-learning program includes both an online course and a test. All employees must complete the program and test within three months of joining RBC and at least once every two years thereafter. • Insider trading, information barriers and employee trading Client due diligence (Know Your Client and Suitability) • Environmental risk • Outsourcing risk • Structured transactions and complex credits • Auditor independence. Policies and controls are reviewed regularly to ensure continued effectiveness. RBC must perform due diligence on new and existing clients both to comply with applicable anti-money laundering, anti-terrorism and economic sanctions legislation and also so we can understand our clients’ needs in offering suitable products and services. To address the various anti-money laundering and anti-terrorism rules, RBC has implemented appropriate scrutiny and monitoring measures in line with regula- tory requirements. This client due diligence helps us to monitor trade suitability within our securities businesses, and more broadly, helps us to ensure we are providing clients with an appropriate range of products and services. Anti-money laundering policy RBC is committed to preventing the use of its financial services for money laundering or terrorist financing purposes. Our Global Anti-Money Laundering Compliance Group is dedicated to the continuous development and mainte- nance of policies, guidelines, training and risk assessment tools and models to help our employees deal with ever- evolving money laundering and terrorism financing risks. Anti-terrorism policy RBC and our directors, officers and employees will not know- ingly enter into transactions with, or provide or assist in providing, directly or indirectly, financial services to, or for the benefit of, states, entities, organizations and individuals targeted by applicable anti- terrorism measures. To effectively meet these require- ments, automated systems scan client names against various terrorist and control lists daily, including scan- ning of payments against the Ethical business practices For more information on RBC’s business integrity, visit rbc.com/responsibility/business Royal Bank of Canada Annual Report 2006 8 Corporate responsibility RBC’s business continuity planning encompasses our response to a wide variety of disruption and crisis scenarios affecting the well-being of our employees, clients, business operations and our communities. The RBC Business Emergency Information Line is set up to advise our employees in the event of an RBC-wide crisis or external situation affecting our ability to access RBC offices or serve our clients. The RBC Reporting Hotline enables employees and third parties around the world to confidentially report questionable internal accounting or auditing matters directly to RBC’s Ombudsman. For more information, visit rbc.com/governance. Office of the Superintendent of Financial Institutions, the Office of Foreign Assets Control and other control lists, as per terrorist financing regulations. Economic sanctions policy RBC businesses, directors, officers and employees will not knowingly conduct business with states, entities, organiza- tions and individuals targeted by the economic sanctions of the jurisdictions where they are located or where they operate, or those jurisdictions otherwise applicable to them. Privacy and information security The Internet and other information technologies have revolutionized the way we do business, enabling us to interact and do business with clients, employees, and other third parties from the con venience of the home or office. At the same time, it also brings legitimate concerns about privacy and security. At RBC, we are dedicated to safeguarding the privacy and confidentiality of personal, business, financial, and other information. In fact, it is one of our highest priorities and remains a cornerstone of our commitment to our clients, employees, and other third parties. We have had a formal Privacy Code since 99, overseen by our Chief Privacy Officer, and we use vigorous security safeguards and internal controls to ensure the privacy and security of information entrusted to us. Fraud prevention RBC places a high priority on protecting clients against potential losses from financial fraud. We work closely with other financial institutions, industry associations and law enforcement authorities globally to combat financial crime. We also have a website on fraud, credit and debit card safety for clients globally, and a publication, Straight Talk, about financial fraud, available through our branch network and online. Voluntary codes of conduct The Canadian banking industry has developed a number of voluntary commitments and codes to protect consumers to which RBC has committed. These are listed at rbc.com/ voluntary-codes-public- commitments, including: • Canadian Code of Practice for Consumer Debit Card Services • Canadian Bankers Association Code of Conduct for authorized insurance activities • Model Code of Conduct for Bank Relations with Small- and Medium-Sized Businesses • Principles of Consumer Protection for Electronic Commerce: A Canadian Framework • Visa Zero Liability Policy • Visa E-Promise. Crisis management RBC’s Crisis Management teams, made up of senior exec- utives across the organization, are responsible for the overall identification, isolation and management of major crises, and are activated when crises emerge that are both within and outside RBC’s control. We have enterprise-wide business continuity manage- ment processes and undergo periodic simulations and exercises to help prepare for possible crises, while testing our contingent strategies and tactics and the capabilities of crisis response teams. Royal Bank of Canada Annual Report 2006 Corporate responsibility 9 Socially responsible investing Investors who wish to express their values through ethical investments are increasingly turning to research firms for solid, third-party analysis of which companies have a positive or negative effect on society and the environment. RBC is included on a number of significant indices that recognize financial, social and environmental leaders. Client care RBC’s vision is “Always earning the right to be our clients’ first choice.” The entire company is focused on that vision, from soliciting and acting on client feedback to maintaining vigilant consumer protection measures to ensuring access to financial services. Responding to feedback Clients surveyed (thousands) 5 1 4 7 8 1 0 5 1 0 0 1 8 9 7 9 2004 2005 2006 Canada United States Every year, RBC businesses track client satisfaction and use feedback to make improve ments. For instance, in 2006, in Canada, we: • Enhanced our online investing site to help investors make more informed decisions • Improved our Interactive Voice Response (IVR) for easier navigation, information and representative access • Significantly reduced our personal account opening process time • Launched a new unlimited transactions account for only $.95 per month. In 2006, in the U.S., we: • Introduced online cheque imaging • Decreased loan turnaround time for small business clients. Fraud prevention RBC has stringent security policies and practices, backed up by around-the-clock resources to prevent and detect potential fraud. In 2006, we introduced guarantees for online banking and self- directed brokerage clients, offering 00 per cent reimburse ment for funds lost through unauthorized transac- tions in their accounts. We have developed a number of fraud-education initiatives including up-to-date tips and alerts, brochures and client presentations. In 2006, we published a new Guide to Security and Privacy and undertook a client education campaign on fraud prevention and identity protection. A resolve to make it right Our formal process for handling client concerns is outlined on our website and in our Straight Talk brochures. Customers whose issues are unresolved following this process may appeal to RBC’s Office of the Ombudsman, which examines decisions made by RBC companies and reviews their compliance with proper business procedures. The Office ensures customers get a fair and impartial hearing and are treated with consid- eration and respect. We also respect the dignity and privacy of all parties involved in the proceedings. Responsible development of products and services RBC follows a defined, rigorous review process before launching any new product or significantly changing an existing one. We evaluate products for a range of risks and ensure they align with our Code of Conduct, with legisla- tion, and with any voluntary consumer protection codes that we have signed. Approval levels within RBC correspond to the level of risk identified for a particular product or service. A cornerstone of investor and client protection is the Know Your Client rule. Our employees are required to make all necessary efforts to understand their clients’ situa- tion and financial and personal objectives before making recommendations. RBC is also committed to providing banking access to a host of previously underserved groups through customized products and services. For information, see our Corporate Responsibility Report and Public Accountability Statement at rbc.com. Royal Bank of Canada Annual Report 2006 20 Corporate responsibility Economic impact ($ millions) Employee compensation and benefits () Dividend payments to common and preferred shareholders Income and other taxes (all jurisdictions) () Goods and services purchased from suppliers of all sizes Community investments including donations, sponsorships () Based on continuing operations. 2006 2005 2004 $ 7,340 $ ,907 2,083 3,900 83 6,736 $ 6,70 ,334 ,554 ,989 2,02 3,700 3,700 59 65 Economic impact Economic development Companies both large and small can help shape the economies of the communities and countries in which they do business, simply through their day-to-day business decisions and actions. At RBC, we have an economic impact as an employer and taxpayer through our activities as a financial services company and as a purchaser of goods and services. For more information on RBC’s economic impact, visit rbc.com/responsibility/economic RBC invests in sustainable economic development, and we are committed to contrib- uting to the success of people and businesses in the commu- nities where we operate. We support: • Programs that address basic needs, such as food banks and shelters • Economic growth in communi- ties where we do business • Initiatives that help build wealth and capacity in Aboriginal communities • Resources to promote economic self-sufficiency • Financial literacy programs. RBC also promotes economic growth through industry part- nerships. For example, we are a member of the Canadian American Business Council, raising awareness of the value of the Canada-U.S. trade relationship and enhancing the overall competitiveness of North American economies. Small business Small business is an important engine driving economic growth. RBC is the marketplace leader in Canada with almost 600,000 small- and medium- sized enterprise clients, while RBC Centura serves almost 60,000 small business clients in the Southeast U.S. Financing is essential for many small businesses to start, operate or grow, and RBC offers a host of credit solutions tailored to meet the needs of diverse businesses at various stages. We also strive to provide the best possible products, advice and expertise to help this sector prosper. Innovation RBC takes a leadership role in supporting innovation and the commercialization of research, and we support projects and organizations that promote learning, innovation and entre- preneurship, such as: • The Medical and Related Sciences (MaRS) project, facilitating research and development, and its commercialization • The Canadian Institute for Advanced Research, helping fuel Canada’s knowledge base by bringing together the most distinguished thinkers from across Canada and around the world. We have made direct invest- ments in a number of promising early-stage ventures across North America through RBC Technology Ventures and its partner funds. Our Strategic Technology Fund has brought investment dollars and our vast knowledge and expertise to budding technology companies in the financial services sector. Purchasing In 2006, we spent $3.9 billion on goods and services from international, national, regional and local suppliers of all sizes. Our procurement group is responsible for sourcing products and services. Our procurement policies are inclusive and aim to promote sustainable business prac- tices and economic develop- ment where possible and appropriate. In maintaining the highest standards, our purchasing policies are reviewed annually. We promote fair purchasing practices and strive to support, whenever possible, the communities in which we operate. We are a founding member of the Canadian Aboriginal and Minority Supplier Council (CAMSC). RBC has been a member of the CAMSC’s U.S. affiliate, the National Minority Supplier Development Council, since 2002. Royal Bank of Canada Annual Report 2006 Corporate responsibility 2 Outside the workplace, RBC employees around the world participate in numerous community activities like the 2006 Juvenile Diabetes Research Foundation (JDRF) Ride for Diabetes Research. Attracting and retaining a talented and highly moti- vated workforce is a crucial part of our ongoing success. Consistently ranked as one of the top employers in Canada, we strive to strengthen our reputation as an employer in all countries in which we do business. Understanding what employees value and need enables us to leverage a flexible and competitive Total Rewards program to support the mutual success of employees and RBC. This comprehensive approach includes compensation, benefits and a positive work environment, along with career and learning oppor- tunities that reward people for skills and contribution. Flexibility within the work environment includes the opportunity for flexible working hours, modified work schedules and telework. Employee savings and share ownership plans are part of the RBC Rewards program and promote a sense of ownership that helps align employee, investor and company objectives. The vast majority of employees are RBC shareholders through these programs. Continuous employee growth and development helps ensure we meet current and future client needs. Employees have access to the training resources and opportunities they need to learn and grow as professionals, including global access to RBC Campus, our web-based learning platform, and Career Advisor, a compre- hensive career management resource. Hiring practices focus on identifying and selecting talented people who share our passion for putting clients first. Diversity is one of RBC’s core values and we have become a recognized leader in Canada for promoting diversity. Leveraging diversity for growth and innovation is both a sound business imperative and the right thing to do for our employees, clients and the communities we serve. Keeping employees informed helps ensure alignment with company goals. RBC’s senior management team regularly meets with employees to discuss the company’s goals, strategies and progress. Employees have access to company information via intranet sites, electronic news magazines, e-mail bulletins, and other communication channels, and are encour- aged to provide feedback and comments in a variety of ways. Listening and responding to employee feedback is part of the RBC culture and we have conducted employee opinion surveys since 98. High levels of employee engage- ment and a strong commit- ment to putting clients first are achieved through under- standing employee views and taking action consistent with employee needs and RBC priorities. Workplace Employment worldwide (as at October 31, 2006) 0 8 4 9 6 , 8 5 8 0 6 , l a t o T 2 4 7 4 5 , 1 6 6 6 4 , a d a n a C 0 8 5 0 1 , 6 5 0 0 1 , s e t a t S d e t i n U 8 5 1 4 , 1 4 1 4 , r e h t O l a n o i t a n r e t n i Number of employees Full-time equivalent positions For more information on RBC’s workplace, visit rbc.com/responsibility/workplace Royal Bank of Canada Annual Report 2006 22 Corporate responsibility RBC is actively working to minimize our risks and pursue opportunities presented by environmental issues. Environment For more information on RBC’s business integrity, visit rbc.com/responsibility/ environment Performance and initiatives We are actively working to minimize our risks and pursue opportunities presented by environmental issues. For example, RBC Technology Ventures is a lead investor in the GEF Clean Technology Fund, and we are committed to this through 2007. We are seeking opportunities to further expand our under- writing, arranging and advisory services for alternative energy financing. We are also focusing on finding more ways to reduce our operational impacts through our SOFT (sourcing, operations, facilities and travel) Footprint program. We commit to reporting our ongoing progress on our Environment website on rbc.com in 2007. For more information, see the Risk management section of the Management’s Discussion and Analysis and our 2006 Corporate Responsibility Report. RBC recognizes that our long-term economic success is dependent on a sound environment and healthy communities. That is why we strive to conduct our business and operational activities in a manner that minimizes environmental risk and recog- nizes environmental market opportunities for the benefit of our shareholders, clients and employees. Environmental policy RBC’s Corporate Environ- mental Policy was originally developed in 99 and supplements the environ- mental section of our Code of Conduct. The Policy’s objec- tive is to guide RBC’s business and operational activities in a manner that respects the prin- ciples of sustainable develop- ment. The Policy is currently under review and a revised version, addressing emerging environmental issues, will be released in 2007. Responsible lending RBC considers potential environmental and social consequences of our lending using our Credit and Project Finance Environmental Risk Management Policy suite. This collection of policies provides the basis upon which we review transactions for environmental issues. These policies require that, where warranted, transactions are reviewed by environmental specialists to proactively identify and manage our envi- ronmental risks. In 2006, RBC recommitted to the revised Equator Principles, a set of voluntary guidelines developed in 2003 to address environmental and social risks associated with project finance. Since our original adoption of the Equator Principles in 2003, we have reviewed 4 projects which qualified for review under our Equator Principles policy. Issues and stakeholder engagement In 2006, we worked with external stakeholders to help identify issues relevant to our business activities and operations, including climate change, forestry, biodiversity and the rights of indigenous peoples. We believe that by engaging stakeholders, we deepen our understanding of these issues and are better able to achieve a sustainable balance between environ- mental stewardship and economic prosperity. Royal Bank of Canada Annual Report 2006 Corporate responsibility 23 In 2006, RBC provided more than $2 million in funding so that community-based organizations could offer after-school programs across Canada, such as this program held at the Braeburn Junior School in Toronto. Community Donations Employee contributions In 2006, RBC contributed more than $83 million to community causes worldwide through donations of more than $42 million and an additional $4 million in the sponsor- ship of community events and national organizations. RBC believes in building prosperity by supporting a broad range of community causes. Our employees and pensioners also make an enor- mous contribution as volun- teers, sharing their financial and business knowledge, time and enthusiasm with thou- sands of community groups worldwide. Donations are a cornerstone of our community programs, with a tradition of philan- thropy dating back to our roots. In fact, we have dona- tions on record as far back as 89. We are one of Canada’s largest corporate donors, and contribute to communi- ties across North America and around the world. We are committed to making a lasting social impact through inspired, responsible giving and by building strong part- nerships with the charitable sector. Our priority areas for funding include programs that: • Help keep kids in school • Support emerging artists • Encourage employee involvement • Help seniors lead healthy and independent lives. 2006 Worldwide RBC donations by geography (C$) 2006 RBC donations in Canada by cause RBC’s Employee Volunteer Grants Program was launched in 999 to support and encourage community involvement. Employees and pensioners who volunteer a minimum of 40 hours a year to a registered charity are eligible for a $500 grant to the organi- zation in their honour. Since 999, RBC has made over 0,700 grants and donated more than $5.35 million to celebrate our employees’ volunteer efforts. Sponsorships Sponsorships are an integral part of RBC’s marketing and promotional activities, and are selected to promote our brand, image and reputation. Sponsorships often include an assortment of benefits such as consumer promotions, on-site and media brand and product exposure, as well as client hosting and staff volunteer opportunities. Our community sponsorships are focused on: Canada $ 35,471,617 International $ 6,928,653 Total $ 42,400,270 Royal Bank of Canada Annual Report 2006 24 Corporate responsibility Social services 20.3% Arts and culture 10% Civic Health Education 8.3% 29.9% 31.5% • Amateur sport: We support the development of amateur athletes by sponsoring grassroots events in local communities to national sport associations. We are the longest-standing supporter of Canada’s Olympic team, dating back to 947, a premier national partner of the Vancouver 200 Olympic and Paralympic Winter Games and a proud sponsor of the Canadian Olympic and Paralympic Teams through 202. RBC also sponsors hockey, snowboarding, free- style skiing, athletics and Special Olympics. • Arts: We believe that healthy vibrant communities are a direct result of investing in creative vision and artistic talent. Our portfolio of interests in this area includes the RBC Canadian Painting Competition, celebrating Canadian visual artists early in their career. We also support community events such as art exhibitions, as well as theatre and orchestra performances. For more information on RBC’s business integrity, visit rbc.com/responsibility/community Management’s Discussion and Analysis Management’s Discussion and Analysis (MD&A) is provided to enable a reader to assess our results of operations, financial condition and future prospects for the fiscal year ended October 31, 2006, 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, 2006. 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). We have reclassified certain prior year information to conform to our current year’s presentation, including reclassifications arising from enhancements to our transfer pricing methodologies and the transfer of a specific business between our segments. For further details, refer to the How we manage our business segments section of this Annual Report. Additional information about us, including our 2006 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. 26 Executive summary 43 Quarterly financial information 72 Risk management 26 Vision and strategic goals 27 Selected financial highlights 28 Overview 30 Financial performance 2006 32 Outlook and objectives for 2007 33 Accounting and control matters 33 Critical accounting policies and estimates 36 Future changes in accounting policies 37 Controls and procedures 38 Consolidated results from continuing operations 38 Total revenue 39 Net interest income and margin 39 Non-interest expense 40 Provision for credit losses 40 Insurance policyholder benefits, claims and acquisition expense 63 41 Taxes 41 Business realignment charges 42 Results by geographic segment 42 Related party transactions 43 Results and trend analysis 45 Fourth quarter 2006 performance 45 Business segment results from continuing operations 46 How we manage our business segments 47 Key financial measures (non-GAAP) 50 RBC Canadian Personal and Business 55 RBC U.S. and International Personal Liquidity and funding risk 75 Credit risk 81 Market risk 84 Operational risk 85 87 Reputation risk 88 Regulatory and legal risk 89 Environmental risk Insurance risk 89 and Business 58 RBC Capital Markets 62 Corporate Support Financial condition 63 Balance sheet data and analysis 64 Capital management 69 Off-balance sheet arrangements 90 Additional risks that may affect future results 92 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 state- ments 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 such statements in this document, in other filings with Canadian regulators or the United States Securities and Exchange Commission (SEC), in reports to shareholders or in other communi- cations. These forward-looking statements include, among others, statements with respect to our medium-term and 2007 objectives, and strategies to achieve our objectives, as well as statements with respect to our beliefs, outlooks, plans, objectives, expectations, anticipations, estimates and intentions. The words “may,” “could,” “should,” “would,” “suspect,” “outlook,” “believe,” “plan,” “anticipate,” “estimate,” “expect,” “intend,” “forecast,” “objective” and words and expressions of similar import are intended to identify forward-looking statements. laws and regulations including tax laws; judicial or regulatory judgments and legal proceedings; the accuracy and completeness of information concerning our clients and counterparties; successful execution of our strategy; our ability to complete and integrate strategic acquisitions and joint ventures successfully; changes in accounting standards, poli- cies and estimates; and our ability to attract and retain key employees and executives. Other factors that may affect future results include: the timely and successful development of new products and services; technological changes; 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; the possible impact on our businesses of international conflicts and other political developments including those relating to the war on terrorism; and our success in anticipating and managing the associated risks. By their very nature, forward-looking statements involve numerous We caution that the foregoing list of important factors that may affect factors and assumptions, and are subject to inherent risks and uncer- tainties, both general and specific, which give rise to the possibility that predictions, forecasts, projections and other forward-looking statements 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 and other risks identified and discussed under the Risk man- agement section; general business and economic conditions in Canada, the United States and other countries in which we conduct business; the impact of the movement of the Canadian dollar relative to other currencies, particularly the U.S. dollar and British pound; the effects of changes in government monetary and other policies; the effects of com- petition in the markets in which we operate; the impact of changes in future results is not exhaustive. 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 uncer- tainties and potential events. 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 factors can be found under the Risk management section and the Additional risks that may affect future results section. Information contained in or otherwise accessible through the websites mentioned does not form a 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 2006 Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 25 Management’s Discussion and Analysis 25 Executive summary Royal Bank of Canada (RY on TSX and NYSE) and its subsidiaries oper- ate 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, insur- ance, corporate and investment banking and transaction processing services on a global basis. Our corporate support team enables business growth with expert professional advice and state-of-the-art processes and technology. We employ approximately 70,000 full- and part-time employees who serve more than 14 million personal, business, public sector and institutional clients through offices in North America and 34 countries around the world. • • We have three client- and geographic-oriented business segments. RBC Canadian Personal and Business consists of our personal and business banking and wealth management businesses in Canada and our global insurance business. RBC U.S. and International Personal and Business consists of our personal and business banking and retail brokerage businesses in the U.S., banking in the Caribbean and private banking internationally. • RBC Capital Markets provides a wide range of corporate and invest- ment 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 that maintain the safety and soundness of our operations, while keeping our capabili- ties 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 prudently 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 our strategic business decisions. Royal Bank of Canada RBC Canadian Personal and Business RBC U.S. and International Personal and Business RBC Capital Markets • Personal Banking • Business Financial Services • Cards and Payment Solutions • Wealth Management • Global Insurance • Wealth Management • Banking • Global Markets • Global Investment Banking and Equity Markets • RBC Dexia Investor Services (1) • Other Global Technology and Operations Global Functions (1) On January 2, 2006, we combined our Institutional & Investor Services (IIS) business with Dexia Funds Services in return for a 50% joint venture interest in RBC Dexia Investor Services (RBC Dexia IS). 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,” which drives our Client First approach, and is exhibited in the conduct of all our activities, including how we deal with our clients, develop our products and services and collaborate across businesses and functions. Our Client First approach focuses on enhancing client satisfaction and loyalty in a cost-efficient manner, even as the needs and expectations of our clients continue to develop. We believe that applying this client focused approach to how we conduct business is critical to achieving our stra- tegic goals. As well, this approach will help us generate strong stable revenue and earnings growth, and lead to continuous improvements in productivity, and ultimately, top quartile financial performance versus our North American peer group. Our domestic market continues to offer significant avenues for growth in both the retail and wholesale sectors. This potential growth, together with the strength of our brand and leading positions in most product categories, provides us with the financial strength to expand internationally. The U.S. is the primary location for such growth, with its geographic proximity, cultural similarity, close trade relationships with Canada and our strength in select markets. In addition, we do business in many other markets where our expertise allows us to compete and strengthen our presence globally. For 2007, our strategic goals remain focused on driving business growth both domestically and internationally by leveraging and building on our strengths. We expect to achieve these goals through ongoing innovation and collaboration among businesses together with our focus on meeting the needs of clients. Royal Bank of Canada Annual Report 2006 26 Management’s Discussion and Analysis • • • In Canada, our goal is to be the undisputed leader in financial services. We continue to leverage our extensive distribution capa- bilities across business lines to maximize distribution effectiveness for personal and business markets. We are also developing innova- tive solutions for retail and wholesale clients, and expanding and improving our distribution network while strengthening the RBC brand by delivering a superior client experience. In the United States, our goal is to build on our strengths in banking, wealth management and capital markets. At RBC Capital Markets, we continue to integrate our mid-market origination and distribu- tion capabilities and develop our product and sector strengths. We are focusing on our primary advisor strategy and on delivering a broader suite of wealth management products at RBC Dain Rauscher. To enhance efficiency, we are combining our capital markets and wealth management operational activities to create an integrated investment bank. We remain focused on enhancing RBC Centura’s operating performance and have taken steps to accelerate our expansion through both de novo branch openings and acquisitions. In addition, we continue to grow our insurance business. Outside North America, our goal is to be a premier provider of selected financial services. RBC Capital Markets continues to enhance distribution by growing niche product and origination capabilities. Global Private Banking is increasing scale through targeted acquisitions, and building additional distribution capa- bilities, expanding the breadth of its products and services, and enhancing its relationship management model. We are reinforcing our position in the Caribbean through organic growth and opera- tional improvements, while continuing to explore opportunities to selectively expand our footprint in fast-growing regions. Our Institutional & Investor Services joint venture, RBC Dexia IS, utilizes its global scale and expanded product capability to grow the number and depth of its client relationships. Guided by our vision and strategic goals, our business segments tailor their strategies to meet client needs as well as strengthening client relationships within their unique operating and competitive environ- ments. The successful execution of our strategies across all retail and wholesale businesses will continue to contribute to the significant enhancement in the quality and diversity of our earnings. Our efforts should also 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 highlights (1) (C$ millions, except per share, number of and percentage amounts) 2006 2005 2004 Table 1 2006 vs. 2005 Increase (decrease) Continuing operations Total revenue Non-interest expense Provision for credit losses Insurance policyholder benefits, claims and acquisition expense Business realignment charges Net income before income taxes and non-controlling interest in subsidiaries Net income from continuing operations Net loss from discontinued operations Net income Segments – net income from continuing operations RBC Canadian Personal and Business RBC U.S. and International Personal and Business RBC Capital Markets Corporate Support Net income from continuing operations Selected information Earnings per share (EPS) – diluted (2) Return on common equity (ROE) (3) Return on risk capital (RORC) (3) Selected information from continuing operations Earnings per share (EPS) – diluted (2) Return on common equity (ROE) (3) Return on risk capital (RORC) (4) Net interest margin (5) Capital ratios (6) Tier 1 capital ratio Total capital ratio Selected balance sheet and other information Total assets Securities Consumer loans Business and government loans Deposits Average common equity (3) Average risk capital (4) Risk-adjusted assets (6) Assets under management Assets under administration – RBC Common share information (2) Shares outstanding (000s) – average basic – RBC Dexia IS (7) – average diluted – end of period Dividends declared per share Dividend yield Common share price (RY on TSX) – close, end of period Market capitalization Business information for continuing operations (number of) Employees (full-time equivalent) Bank branches Automated banking machines (ABM) Period average US$ equivalent of C$1.00 (8) Period-end US$ equivalent of C$1.00 (1) $ 20,637 11,495 429 2,509 – $ 19,184 11,357 455 2,625 45 $ 17,802 10,833 346 2,124 177 $ $ $ $ $ $ $ $ $ $ 6,204 4,757 (29) 4,728 2,794 444 1,407 112 4,757 3.59 23.5% 36.7% 3.61 23.3% 37.0% 1.35% 9.6% 11.9% 4,702 3,437 (50) 3,387 2,304 387 760 (14) 3,437 2.57 18.0% 29.3% 2.61 18.1% 29.7% 1.52% 9.6% 13.1% $ $ $ $ $ 4,322 3,023 (220) 2,803 2,043 214 827 (61) 3,023 2.11 $ 15.6% 24.6% 2.28 $ 16.8% 26.5% 1.53% 8.9% 12.4% $ 536,780 184,869 148,732 61,207 343,523 19,900 12,750 223,709 143,100 525,800 1,893,000 $ 469,521 160,495 138,288 53,626 306,860 18,600 11,450 197,004 118,800 1,778,200 – $ 426,222 128,946 125,302 47,258 270,959 17,800 11,300 183,409 102,900 1,593,900 – 1,279,956 1,299,785 1,280,890 1.44 3.1% 49.80 63,788 $ $ 1,283,433 1,304,680 1,293,502 1.18 3.2% 41.67 53,894 $ $ 1,293,465 1,311,016 1,289,496 1.01 3.3% 31.70 40,877 $ $ $ $ $ $ 1,453 138 (26) (116) (45) 1,502 1,320 21 1,341 490 57 647 126 1,320 1.02 550 bps 740 bps 1.00 520 bps 730 bps n.m. – bps (120)bps $ 67,259 24,374 10,444 7,581 36,663 1,300 1,300 26,705 24,300 n.m. n.m. (3,477) (4,895) (12,612) .26 (10)bps 8.13 9,894 $ $ 60,858 1,443 4,232 .883 .890 $ 60,012 1,419 4,277 .824 .847 $ 61,003 1,415 4,432 $ .762 .821 $ 846 24 (45) .06 .04 7.6% 1.2% (5.7)% (4.4)% n.m. 31.9% 38.4% n.m. 39.6% 21.3% 14.7% 85.1% n.m. 38.4% 39.7% n.m. n.m. 38.3% n.m. n.m. n.m. n.m. n.m. 14.3% 15.2% 7.6% 14.1% 11.9% 7.0% 11.4% 13.6% 20.5% n.m. n.m. (.3)% (.4)% (1.0)% 22.0% n.m. 19.5% 18.4% 1.4% 1.7% (1.1)% 7.2% 5.1% (2) (3) (4) (5) (6) (7) Certain consolidated and segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. On April 6, 2006, we paid a stock dividend of one common share on each of our issued and outstanding common shares. The effect is the same as a two-for-one split of our common shares. All common share and per share information has been retroactively adjusted to reflect the stock dividend. Average common equity and Return on common equity are calculated using month-end balances for the period. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Average risk capital and the Return on risk capital are non-GAAP financial measures. For further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. 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. Calculated using guidelines issued by the Office of the Superintendent of Financial Institutions Canada (OSFI). Assets under administration – RBC Dexia IS represents the total assets under administration (AUA) of the joint venture, of which we have a 50% ownership interest. RBC Dexia IS was created on January 2, 2006, and we contributed AUA of $1,400 billion to the joint venture at that time. As RBC Dexia IS reports on a one-month lag, Assets under administration – RBC Dexia IS are as at September 30, 2006. Average amounts are calculated using month-end spot rates for the period. (8) n.m. not meaningful Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 27 Overview Overview of 2006 We achieved record earnings performance this year, reflecting strong business growth across all business segments and our successful execution of growth initiatives, despite the negative impact of the strong Canadian dollar on our foreign currency translated results. Our strong results were also underpinned by continuing favourable economic condi- tions in both domestic and international markets. Executing our initiatives In Canada, we continued to strengthen our leadership position in most major product categories by enhancing our products and services and expanding our distribution network to better meet our client needs and deepen client relationships. We are the fastest growing mutual fund company in the country, based on net sales, and the leader in most of our capital markets lines of business. We have leveraged our leading position in capital markets to grow our mid-market businesses and have become a major player in the Maple bond market, helping global companies to issue Canadian dollar debt. The strength of our brand, together with our leadership position in most major product categories in Canada, provides us the financial strength to expand our business globally. In the U.S., we continued to build scale and capability in all our major businesses through a combination of organic growth and acquisi- tions. We announced two agreements (1) that will expand our banking capabilities in the Southeast U.S. The acquisition of Atlanta-based Flag Financial Corporation will significantly increase our banking presence in key Georgia markets. In addition, we also recently announced an agree- ment (1) to acquire 39 bank branches in Alabama owned by AmSouth Bank, which will make us the seventh largest financial institution in that state, as measured by deposits. These two acquisitions, which are expected to close in early 2007, complement our de novo branch openings in high-growth areas. We acquired Delaware-based American Guaranty & Trust Company, enabling us to provide U.S. trust solutions to high net worth clients. We also expanded our U.S. investment bank- ing and fixed income capabilities. We announced an agreement (1) to acquire the broker-dealer business and certain assets of Carlin Financial Group of New York, which will provide our clients with a best-in-class North American electronic execution platform. In November 2006, we announced an agreement (1) to acquire Daniels & Associates, L.P., the most active M&A advisor based on transactions to the cable, telecom and broadcast industries in the U.S., enabling us to better serve our investment banking clients. These two acquisitions are expected to close in the first quarter of 2007. Internationally, we expanded our distribution network, products and services, and focused our expansion in fast-growing markets and regions. During the year, we acquired Abacus Financial Services Group, which expanded our client base and significantly strengthened our wealth management services in the U.K. and Channel Islands. We also recognized the growing importance of the Chinese market and have made a number of strategic investments in China during the year. We upgraded our representative banking office in Beijing to branch status, enabling us to provide a wide range of services to retail and wholesale clients. We were a co-lead manager of the institutional tranche for the Industrial and Commercial Bank of China’s initial public offering (IPO). We strategically reduced our exposure to property catastrophe reinsur- ance during the year, as we ceased underwriting new business and focused on managing the remaining claim liabilities related to previous commitments. In all our operations, we sought out opportunities for strong and diversified earnings growth, while enhancing client satisfaction and loyalty in a cost-efficient manner. To ensure sound corporate governance, we continued to commit ourselves to establishing and maintaining adequate disclosure controls and procedures, as well as internal control over financial reporting in order to provide reasonable assurance regarding the reliability of our financial disclosure, and ultimately, maintaining our clients’ trust and investors’ confidence. We have also dedicated significant resources and management attention to the implementation of Basel II (International Convergence of Capital Measurement and Capital Standards: A Revised Framework), and have made significant progress towards compliance. For further information, refer to the Accounting and control matters and Risk management sections. 2006 Economic and market review In 2006, North American economic conditions were generally favour- able, benefiting from low but rising interest rates, solid yet slowing housing markets, strong employment levels and higher wages, and healthy growth in business investment. The Bank of Canada has maintained the overnight rate at 4.25% since May after 7 consecutive 25 basis point (bps) increases, which served to help slow economic activity and contain inflationary pressures. The Canadian economy remained robust with an estimated growth rate of 2.8%, primarily underpinned by strong domestic demand. These factors were partially offset by a weakening in exports and manufacturing activities against the backdrop of a strong Canadian dollar, high but falling energy prices, slowing U.S. demand and competition from emerging markets. The U.S. Federal Reserve has held the federal funds rate unchanged at 5.25% since June after 17 consecutive rate increases taking into account slow- ing economic growth and more contained inflationary pressures. Real GDP in the U.S. grew by an estimated 3.4%, 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. Strong consumer lending was supported by high employment levels, continued wage growth, and a relatively low interest rate envi- ronment. Canadian households continued to redeploy their liquidity into wealth management products, resulting in a shift from chequing and savings accounts towards mutual funds and fixed-term deposits to take advantage of higher returns. The favourable credit environment, together with the solid debt-servicing capacity of households, continued to support strong consumer credit quality. Business lending remained solid, albeit in part offset by surpluses of internally generated funds available for capital and inventory investment. Strong business credit quality continued to reflect solid corporate earnings and healthy balance sheets as well as a benign credit environment. Capital market conditions were generally favourable, character- ized by high equity market volatility and strong performance of natural resource-based equities. M&A activity in Canada rivaled the record high set in 2000. Equity origination activity weakened in the year in part reflecting slower equity market activity outside the resource sector, while debt origination activity in the U.S. and Europe was also down in part due to rising interest rates and the negative impact of the strengthening of the Canadian dollar. Specified items A number of specific items were identified during 2006, including a favourable resolution of an income tax audit related to prior years, an adjustment to increase our credit card customer loyalty reward program liability, and additional hurricane-related charges. These items had minimal impacts on our overall results as their effects largely offset each other. (1) These agreements are subject to customary closing conditions including regulatory approval. Royal Bank of Canada Annual Report 2006 28 Management’s Discussion and Analysis Specified items (C$ millions) Income tax reduction Agreement termination fee General allowance reversal Net gain on the exchange of NYSE seats for NYX shares Amounts related to the transfer of IIS to RBC Dexia IS Credit card customer loyalty reward program liability adjustment Hurricane-related charges Enron litigation provision Business realignment charges (1) Goodwill impairment (2) Rabobank settlement costs 2006 2005 2004 Before-tax After-tax Before-tax After-tax Before-tax After-tax Segments Table 2 $ – – 175 $ – – 113 $ n.a. 51 50 40 (16) (72) (61) – – – – $ 70 33 33 23 (19) (47) (61) – – – – $ – – – – – – (203) (591) (58) – – $ – – – – – – (203) (326) (37) – – – – – – – (192) (130) n.a. Corporate Support RBC Canadian Personal and Business RBC Capital Markets and RBC Canadian Personal and Business RBC Capital Markets and RBC U.S. and International Personal and Business RBC Capital Markets RBC Canadian Personal and Business – – – – – (125) (130) (74) RBC Canadian Personal and Business RBC Capital Markets All segments Discontinued operations RBC Capital Markets (1) (2) n.a. For the year ended October 31, 2005, $29 million after-tax related to continuing operations and $8 million after-tax related to discontinued operations. For October 31, 2004, $116 million after-tax related to continuing operations and $9 million after-tax related to discontinued operations. Relates to RBC Mortgage Company which has been classified as discontinued operations. not applicable Income tax reduction We realized a favourable resolution of an income tax audit related to prior years, resulting in a $70 million reduction in income tax expense. Agreement termination fee We received $51 million related to the termination of an agreement. General allowance reversal We reversed $50 million of the general allowance related to our cor- porate loan portfolio in RBC Capital Markets, in light of the continued favourable credit conditions and the strengthening of the credit quality of our corporate loan portfolio. Net gain on the exchange of NYSE seats for NYX shares The broker-dealer subsidiaries of RBC Capital Markets and RBC U.S. and International Personal and Business received shares in NYSE Group (NYX) in exchange for their respective New York Stock Exchange (NYSE) seats. This exchange resulted in a net gain of $32 million being recog- nized in RBC Capital Markets and a net gain of $8 million in RBC U.S. and International Personal and Business. Amounts related to the transfer of IIS to RBC Dexia IS On January 2, 2006, we combined our Institutional & Investor Services (IIS) business, previously part of RBC Capital Markets, with the Dexia Fund Services business of Dexia Banque Internationale à Luxembourg (Dexia) in return for a 50% joint venture interest in the new company, RBC Dexia Investor Services (RBC Dexia IS). Net charges incurred associated with the transfer of our IIS business to RBC Dexia IS were $16 million before-tax ($19 million after-tax which included a write-off of deferred taxes). Credit card customer loyalty reward program liability adjustment We made a $72 million adjustment to increase our credit card customer loyalty reward program liability largely as a result of refinements to our model assumptions to reflect higher customer utilization of RBC Rewards points. Hurricane-related charges We recorded a $61 million (before- and after-tax) charge in our insurance business for additional estimated net claims for damages predominantly related to Hurricane Wilma which occurred in late October 2005. Overview of 2005 In 2005, our strong earnings were supported by our successful execu- tion of client-focused initiatives and favourable economic conditions, despite the negative impact of the Enron Corp. litigation-related provision and charges for estimated net claims related to hurricanes Katrina, Rita and Wilma. In conjunction with our objective of improving revenue growth, we realigned our organization into four segments, three business segments and Corporate Support, to create a more efficient organization, which better meets our client needs and enhances shareholder value. This realignment also provided the opportunity to introduce new leadership at the business segment levels, to eliminate redundant positions, to streamline processes as well as to implement cost-containment initia- tives. We also divested non-strategic operations and assets, expanded our distribution network and product offerings, and sought out new revenue growth opportunities while enhancing our service to clients in a cost-efficient manner. In 2005, the Canadian economy grew by 2.9%, 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 stronger Canadian dollar and higher energy prices. The U.S. economy recorded a growth rate of 3.2%, 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 actions to mitigate the uncertainties regard- ing Enron-related matters, including the settlement of our part of the MegaClaims bankruptcy lawsuit brought by Enron against us and a num- ber 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 after-tax (US$276 million after-tax) for Enron litigation-related matters (Enron provision), including a securities class action lawsuit brought on behalf of Enron securities holders in a federal court in Texas. In the fourth quarter of 2005, 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. This divestiture enabled us to focus on our core life insur- ance business in the U.S. We completed the sale of certain assets of RBC Mortgage Company (RBC Mortgage) to Home123 Corporation, as RBC Mortgage was no longer a core business to our U.S. operations. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 29 Overview of 2004 In 2004, we delivered solid earnings growth in most of our businesses, improved credit quality and grew market shares in key products in Canada. We launched our Client First approach to realign our opera- tions, to grow revenue and to create long-term value for shareholders and clients. In 2004, the Canadian economy grew by 3.3% on declining interest rates and strengthening consumer demand. The U.S. economy also expanded rapidly at a growth rate of 3.9% against a low interest rate environment and an improved labour market. The favourable credit environment supported demand for consumer loans and investment products, while business lending started to pick up with increased investment in capital equipment and inventories. During 2004, there were several important corporate develop- ments and transactions. We incurred a $192 million business realignment charge. We had a $130 million write-off of goodwill related to RBC Mortgage Company. We also announced a $74 million after-tax settlement net of a related reduction in compensation and tax expense related to a dispute with Cooperatieve Centrale Raiffeisen- Boerenleenbank, B.A. (Rabobank settlement costs). Our insurance business acquired the Canadian operations of Provident Life and Accident Insurance Company (UnumProvident), a wholly owned subsid- iary of UnumProvident Corporation. We also acquired William R. Hough & Co. Inc., a full-service investment firm specializing in fixed income sales, trading and underwriting primarily in the Southeast U.S., which provides synergies to our U.S. debt business in RBC Capital Markets. In addition, we acquired the Provident Financial Group’s Florida banking operations providing us with continued expansion opportunities in this fast-growing market. Financial performance 2006 Record net income of $4,728 million for the year ended October 31, 2006, was up $1,341 million, or 40%, from a year ago. Diluted EPS were $3.59, up 40%, over the prior year. Return on common equity was 23.5%. Excluding the prior year Enron provision, net income increased $1,015 million, or 27%, and diluted EPS were up $.77, or 27%, over the prior year. Results excluding the prior year Enron provision are a non- GAAP measure. For a reconciliation and further discussion, refer to the Key financial measures (non-GAAP) section. Continuing operations Net income from continuing operations for 2006 was $4,757 million, up $1,320 million, or 38%, from a year ago. Diluted EPS were $3.61, up $1.00, or 38%, over the prior year. ROE was 23.3%. Excluding the prior year Enron provision, net income increased $944 million, or 26% and diluted EPS were up $.75, or 26%, over the prior year. The increase largely reflected strong earnings momentum and solid growth across all our business segments. The reduction in our effective income tax rate and lower hurricane-related charges in the current year, also contributed to the improvement in our results. These factors were partially offset by higher variable compensation reflecting stronger business performance and higher costs related to our growth initiatives. This growth was achieved despite the $125 million reduction in the translated value of our U.S. dollar-denominated earnings due to the stronger Canadian dollar. Total revenue increased $1,453 million, or 8%, from a year ago, largely due to record trading results on improved market conditions and solid business growth in our wealth management and banking businesses reflecting our successful execution of 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 translated U.S. dollar-denominated revenue, lower debt and equity origination activity and certain favourable items recorded in the prior year. These items included 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 sale of LIS. Non-interest expense increased $138 million, or 1%, compared to the prior year largely reflecting the prior year Enron provision. Excluding the Enron provision, non-interest expense increased $729 million, or 7%. The increase largely reflected higher variable compensation pri- marily in RBC Capital Markets and our wealth management businesses reflecting strong business performance. Higher costs in support of our business growth initiatives also contributed to the increase. These costs included a higher level of personnel in our distribution network, increased costs related to technology development, higher marketing and advertising costs and a higher number of branches. The increase in non-interest expense was partially offset by the $215 million reduc- tion in the translated value of U.S. dollar-denominated expenses due to the stronger Canadian dollar and the prior year settlement of the Enron MegaClaims bankruptcy lawsuit. Royal Bank of Canada Annual Report 2006 30 Management’s Discussion and Analysis Total provision for credit losses decreased $26 million, or 6%, from a year ago. The decrease largely reflected a $50 million reversal of the general allowance this year, the favourable impact of the higher level of securitized credit cards, and the continued strong credit quality of our U.S. loan portfolio. The prior year also included 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 portfolios. Insurance policyholder benefits, claims and acquisition expense decreased $116 million, or 4%, compared to the prior year. The decrease primarily reflected a $142 million (before- and after-tax) reduction in hurricane-related charges for estimated 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 this year. Discontinued operations The net loss for discontinued operations for 2006 was $29 million com- pared to a net loss of $50 million for 2005. The current period net loss mainly reflected charges related to the wind-down of RBC Mortgage. The prior year net loss reflected operating losses prior to the sale of certain assets of RBC Mortgage to Home123 Corporation on September 2, 2005, as well as subsequent charges related to the sale and wind-down of operations, including the costs of closing RBC Mortgage’s Chicago office and certain branches, employee incentive payments and the writedown of certain assets. As at October 31, 2006, we have substantially disposed of the assets and obligations related to RBC Mortgage that were not transferred to Home123 Corporation. Capital ratios The Tier 1 capital ratio of 9.6% was unchanged from a year ago as strong internal capital generation, the reclassification of innovative capi- tal from Tier 2, and the net issuance of preferred shares were offset by share repurchases and robust balance sheet growth. The Total capital ratio of 11.9% was down 120 bps from the previous year largely reflect- ing our redemption of subordinated debentures in 2006. Impact of U.S. vs. Canadian dollar The translated value of our U.S. dollar-denominated results is impacted by fluctuations in the U.S./Canadian dollar exchange rate. Table 3 depicts the effect of translating current year results at the current exchange rate in comparison to the historical period’s exchange rate. We believe this provides the reader with the ability to assess the underlying results on a more comparable basis, particularly given the magnitude of the recent changes in the exchange rate and the resulting impact on our results. Impact of U.S. dollar vs. Canadian dollar Table 3 (C$ millions, except per share amounts) Reduced total revenue Reduced non-interest expense Reduced net income from continuing operations Reduced net income 2006 vs. 2005 2005 vs. 2004 $ 425 $ 215 125 123 420 260 65 61 .05 .05 8% Reduced diluted EPS – continuing operations $ Reduced diluted EPS $ .10 $ .09 $ Percentage change in average US$ equivalent of C$1.00 (1) 7% (1) Average amounts are calculated using month-end spot rates for the period. In 2006, the Canadian dollar appreciated 7% on average relative to the U.S. dollar from the prior year, resulting in a $123 million decrease in the translated value of our U.S. dollar-denominated net income and a reduction of $.09 on our current year’s diluted EPS. U.S. dollar- denominated net income from continuing operations was reduced by $125 million and diluted EPS by $.10 compared to the prior year. 2006 Performance vs. objectives Table 4 (C$ millions, except per share amounts) Diluted earnings per share (EPS) growth (2) Return on common equity (ROE) Revenue growth Operating leverage (3) Portfolio quality (4) Capital management: Tier 1 capital ratio (5) Dividend payout ratio 2006 Objectives (1) 2006 Performance 20%+ 20%+ 6–8% >3% .40–.50% 8%+ 40–50% 40% 23.5% 8% 1% .23% 9.6% 40% (1) (2) (3) (4) (5) Our 2006 financial objectives were established late in fiscal 2005 and reflected our economic and business outlook for 2006. We established objectives for 2006 to position us as a top quartile performer with respect to total return to shareholders relative to our Canadian and U.S. peers. At the time these objectives were established, we expected an average Canadian dollar value of US$.817 in 2006; however, the actual dollar value was US$.883. Based on 2005 total reported diluted EPS of $5.13, which has been retroactively adjusted to $2.57 to reflect our stock dividend paid on April 2, 2006. Operating leverage is the difference between our revenue growth rate and the non-interest expense growth rate. Our 2006 objective for operating leverage was based on 2005 non-interest expense excluding the Enron provision of $591 million. Ratio of specific provision for credit losses to average loans and acceptances. Calculated using guidelines issued by the OSFI. 2006 Annual objectives In 2006, we met all but one of our objectives with the exception of our operating leverage objective. Diluted EPS growth was 40% (27% exclud- ing the Enron provision) and ROE was 23.5%, exceeding their targets of diluted EPS growth of 20% plus and ROE of 20% plus, largely reflecting strong earnings growth. Revenue growth of 8% was at the top end of our range of 6% to 8%, despite the negative impact of a stronger Canadian dollar on our U.S. dollar- and GBP-denominated revenue, primarily due to strong trading revenue and growth in our banking and wealth man- agement businesses. Favourable credit conditions in 2006 continued to support our strong credit quality ratio of .23%, which was significantly better than our objective of .40% to .50%. We also maintained our solid capital position with a Tier 1 capital ratio of 9.6%, which was signifi- cantly above our target of 8% plus, due to strong earnings generation and net capital issuances. Our dividend payout ratio of 40% met our target payout ratio of 40% to 50% due in large part to the 22% increase in dividends during the year. However, we missed our operating lever- age target for the year as it was impacted by our business mix and certain factors which contribute to our earnings growth but were not appropriately captured in this measure. These factors included the impact of tax-advantaged sources, consolidated VIEs and insurance- related revenue and expense. Accordingly, we have adjusted our 2007 operating leverage calculation to incorporate these factors in order to more appropriately reflect the performance of our businesses going for- ward. If this new approach was applied to our 2006 results, our adjusted operating leverage would have been 2.5% (1). Medium-term objective Commencing in 2006, our medium-term objective is to consistently achieve top quartile (2) total shareholder return (TSR) (3) 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 5-year (4) average annual TSR of 20% (28% in U.S. dollars) ranks us in the top quartile against our peer group and compares favourably with the 5-year average annual TSR for our peer group of 8% (16% in U.S. dollars). Our performance reflects our strong financial results, including returns on our investment in our businesses, and management of our risks which has allowed us to successfully meet most of our annual earnings, capital and credit quality objectives over the last two years. Dividends paid over the five-year period have increased at an average annual compounded rate of 16%. (1) (2) (3) (4) Adjusted operating leverage is a non-GAAP financial measure. For a further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Versus seven large Canadian financial institutions (Manulife Financial Corporation, Bank of Nova Scotia, TD Bank Financial Group, BMO Financial Group, Sun Life Financial Inc., Canadian Imperial Bank of Commerce and National Bank of Canada) and 13 U.S. financial institutions (Bank of America, JP Morgan Chase & Co., Wells Fargo & Company, Wachovia Corporation, US Bancorp, Sun Trust Banks, Inc., The Bank of New York, BB&T Corporation, Fifth Third Bancorp, National City Corporation, The PNC Financial Services Group, KeyCorp and Northern Trust Corporation). Total shareholder return is calculated based on share price appreciation from October 31, 2001 to October 31, 2006 plus reinvested dividend income over this period. This refers to the period October 31, 2001 to October 31, 2006. Five-year average annual total shareholder return (C$) 30% 24% 18% 12% 6% 0% RBC Canadian peer group Total peer group U.S. peer group Five-year average annual total shareholder return (US$) 30% 24% 18% 12% 6% 0% RBC Canadian peer group Total peer group U.S. peer group Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 31 Outlook and objectives for 2007 Economic outlook The Canadian economy is expected to remain strong, with real GDP growth of 2.7% in 2007, compared to an estimated 2.8% in 2006. Domestic demand is likely to remain the key driver of economic growth. Consumer spending should continue to benefit from a solid labour mar- ket, good household balance sheet conditions, relatively stable interest rates and tax relief, while solid business investment in capital goods underpinned by a firm currency and strong corporate balance sheets is anticipated. We expect the Bank of Canada to ease interest rates in the latter part of 2007 taking into account an anticipated slowing of economic growth in part reflecting the waning U.S. demand for Canadian exports and the expectation that inflation will fall in line with the Bank of Canada’s target. Real GDP growth in the U.S. is expected to slow to 2.6% in 2007 from an estimated 3.4% for 2006, largely attributable to slower growth in consumer spending and a cooling housing market. Growth in con- sumer spending is projected to slow in response to the lagged effects of higher interest rates and lower gains in household wealth amid a soften- ing housing market. However, a major slowdown in consumer spending is unlikely as strong household liquidity and tight labour market condi- tions should continue to support growth. Business investment should remain solid, aided by healthy corporate balance sheets. The U.S. trade deficit is likely to recover moderately, reflecting increasing demand from foreign nations given firm global growth, the delayed impact of the weakening U.S. dollar on exports, and declining import growth as the economy gears down. We anticipate the U.S. Federal Reserve to lower interest rates in the second half of 2007 in response to slower economic growth and more contained inflationary pressures. Business outlook Consumer lending growth is expected to moderate in 2007, largely driven by lower construction and resale activity in housing markets and somewhat slower growth in consumer spending. We expect business lending to remain solid with ongoing business investment in inventories, machinery and equipment, albeit in part constrained by continued high corporate liquidity. While a gradual deterioration in credit quality is anticipated, we expect consumer and business credit quality to remain solid in a histori- cal context, with an anticipated increase in provision for credit losses primarily resulting from higher loan volume and lower recoveries. The outlook for capital markets globally is expected to remain relatively favourable with stable interest rates and improving equity markets. We expect a modest rebound in origination activity, which will be partially offset by a weakening in M&A activity from a near historical high in 2006. Equity origination activity is expected to increase from a relatively slow 2006 as markets other than the resource and income trust sectors should improve, while debt origination is expected to benefit from municipal banking activity in new sectors and growth in U.S. dollar distribution. In addition, core lending activities are expected to increase as spread compression is showing signs of abating, while term is extending. 2007 Objectives Diluted earnings per share (EPS) growth Adjusted operating leverage (1) Return on common equity (ROE) Tier 1 capital ratio (2) Dividend payout ratio Table 5 10%+ >3% 20%+ 8%+ 40–50% (1) (2) Adjusted operating leverage is 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 VIEs, accounting adjustments related to the new Financial Instruments Standard and Insurance-related revenue. Non-interest expense excludes Insurance-related expense. This is a non-GAAP measure. For a further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Calculated using guidelines issued by the OSFI. Our primary objective continues to focus on providing top quartile total shareholder return (TSR) (1) relative to our North American peers (2). This medium-term objective requires our focus on both current performance as well as prudent investment in higher return businesses that will provide sustainable competitive advantage and stable earnings growth. For 2007, our objectives have been established based on our economic and business outlooks, including a robust Canadian economy with continuing strong consumer spending and solid business invest- ment. In the U.S., we expect a moderately slower economy, largely attributable to slightly weaker growth in consumer spending and a cooling housing market. We expect to continue to benefit from relatively favourable equity markets, a relatively stable interest rate environment, and strong domestic fiscal conditions. Our 2007 diluted EPS growth objective of 10% plus is lower than our 2006 objective, as our 2005 earnings included the impact of the Enron provision and charges for estimated net claims related to hur- ricanes Katrina, Rita and Wilma. Our commitment to strong revenue growth and prudent cost containment continues to be encapsulated in our adjusted operating leverage objective, which remains greater than 3%. However, we have adjusted our operating leverage calculation for 2007 to more appropriately reflect the performance of our businesses, and to address the factors that were not appropriately captured in the ratio previously. The adjusted operating leverage ratio now includes the gross up adjustment for certain tax-advantaged income (Canadian tax- able corporate dividends), and excludes our insurance-related revenue and expense, amounts related to the consolidation of variable interest entities (VIEs), and accounting adjustments related to the new Financial Instruments Standard. Our objective for ROE remains unchanged at 20% plus. We also retained our Tier 1 capital and dividend payout ratio tar- gets, which reflect sound and effective management of capital resources. Our Tier 1 capital ratio target remains greater than 8%, which compares favourably to the target of 7% set by our primary regulator (OSFI). Our dividend payout ratio also remains unchanged at 40% to 50%. Our rev- enue growth target is reflected in our earnings per share and adjusted operating leverage objectives, and we believe our portfolio quality is ade- quately captured in our profitability and other objectives. Accordingly, we do not have 2007 objectives for revenue and credit quality. (1) (2) Total shareholder return is calculated based on share price appreciation plus dividend income. Includes seven large Canadian financial institutions (Manulife Financial Corporation, Bank of Nova Scotia, TD Bank Financial Group, BMO Financial Group, Sun Life Financial Inc., Canadian Imperial Bank of Commerce and National Bank of Canada) and 13 U.S. financial institutions (Bank of America, JP Morgan Chase & Co., Wells Fargo & Company, Wachovia Corporation, US Bancorp, Sun Trust Banks, Inc., The Bank of New York, BB&T Corporation, Fifth Third Bancorp, National City Corporation, The PNC Financial Services Group, KeyCorp and Northern Trust Corporation). Royal Bank of Canada Annual Report 2006 32 Management’s Discussion and Analysis Accounting and control matters Critical accounting policies and estimates Application of critical accounting policies and estimates Our significant accounting policies are contained in Note 1 to the Consolidated Financial Statements. Certain of these policies, as well as estimates made by management in applying such policies, are recog- nized 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, securitization, variable interest entities, pensions and other post-employment benefits, income taxes, and other-than-temporary impairment of investment securities. 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 includ- ing loans, acceptances, letters of credit and guarantees, and unfunded commitments, as at the balance sheet date. The allowance for credit losses is comprised of the specific allowance and the general allowance. The specific allowance is determined through management’s identifica- tion 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 informa- tion. Our lending portfolio, excluding credit card balances as they are directly written off after payments are 180 days past due, 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 pro- cess 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 experi- ence 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 absorb probable losses on impaired loans. Loan impairment is recognized when, based on man- agement’s judgment, there is no longer reasonable assurance that all interest and principal payments will be made in accordance with the loan agreement. For large business and government portfolios, which are continu- ously 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 bor- rower, financially responsible guarantors and the realization of collateral. The amounts expected to be recovered are reduced by estimated collec- tion costs and discounted at the effective interest rate of the obligation. For homogeneous portfolios, 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 experience, 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 absorb probable losses on accounts in the lending portfolio that have not yet been specifically classified as impaired. This estimation is based on a number of assump- tions including: (i) the level of unidentified problem loans given current economic and business conditions; (ii) the timing of the realization of impairment; (iii) the committed amount that will be drawn when the account is classified as impaired; 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 credit process including underwriting, limit setting and the workout process in order to adjust historical experience to better reflect the current environment. In addi- tion, current credit information including portfolio composition, credit quality trends and economic and business information are assessed to determine the appropriate allowance level. For large business and government loans, the general allowance level is estimated based on management’s judgment of business and economic conditions, historical loss experience, the impact of policy changes and other relevant factors. The range of loss is derived through the application of a number of risk parameters related to committed obligations. The key parameters used are probability of default (PD), loss given default (LGD) and usage given default (UGD). PDs are delineated by borrower type and risk rating; LGDs are largely based on seniority of debt, collateral security and client type, and UGDs are applied based on risk rating. These parameters are based on long-term historical loss experience (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 qual- itative assessments of a borrower’s financial condition in order to assign it 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 loans, including residential mortgages, credit cards, and personal and small business loans, probable losses are estimated on a portfolio basis. Long-term historical loss experience is 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 impreci- sion inherent in the allowance methodologies. Any fundamental change in methodology is subject to independent vetting and review. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 33 Total allowance for credit losses Based on the procedures discussed above, management is of the opinion that the total allowance for credit losses of $1,486 million is adequate to absorb estimated credit losses incurred in the lending port- folio as at October 31, 2006. This amount includes $77 million classified in Other liabilities, which relates to letters of credit and guarantees and unfunded commitments. Fair value of financial instruments In accordance with GAAP, certain financial instruments are carried on our balance sheet at their fair value. These financial instruments com- prise securities held in our trading portfolio, obligations related to securities sold short and derivative financial instruments (excluding non-trading derivatives qualifying for hedge accounting). At October 31, 2006, approximately $184 billion, or 35%, of our financial assets and $80 billion, or 19%, of our financial liabilities were carried at fair value ($164 billion, or 36%, of financial assets and $75 billion, or 19%, of financial liabilities at October 31, 2005). Note 2 to our Consolidated Financial Statements provides disclosure of the estimated fair value of all our financial instruments at October 31, 2006. 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 prices in an active market. 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 profile or internal or external valuation models using market-based inputs to estimate the fair value. The determination of fair value for actively traded financial instru- ments 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 the potential exists that the amount realized on sale will 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 adjust- ments are calculated to reflect the cost of unwinding a larger than normal market risk. The majority of our trading securities portfolio and obligations related to securities sold short comprise or relate to actively traded debt and equity securities, which are carried at fair value based on avail- able quoted prices. As few derivative financial instruments 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 instru- ments, 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, 2006, and October 31, 2005. Assets and liabilities carried at fair value by valuation methodology Table 6 (C$ millions, except percentage amounts) Fair value Based on Quoted market prices Pricing models with significant observable market parameters Pricing models with significant unobservable market parameters 2006 2005 Financial assets Financial liabilities Financial assets Financial liabilities Trading securities Derivatives Obligations related to securities sold short Derivatives Trading securities Derivatives Obligations related to securities sold short Derivatives $ 147,237 $ 37,008 $ 38,252 $ 41,728 $ 125,760 $ 38,341 $ 32,391 $ 42,404 87% – 97% – 85% – 93% 13 – 100 – 3 – 100 15 – – 99 1 7 – – 100 – 100% 100% 100% 100% 100% 100% 100% 100% 2006 vs. 2005 The increases of $21.5 billion in Trading securities and $5.9 billion in Obligations related to securities sold short in 2006 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. These activities are consistent with our strategy for these businesses and the increases in 2006 are within the approved risk limits. The determination of fair value where quoted market 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. As outlined in Note 1 to our Consolidated Financial Statements, changes in the fair value of Trading securities and Obligations related to securities sold short are recognized as Trading revenue in Non-interest income and changes in the fair value of our trading and non-trading derivatives that do not qualify for hedge accounting are recognized in Non-interest income. Royal Bank of Canada Annual Report 2006 34 Management’s Discussion and Analysis Securitization We periodically securitize residential mortgages, credit card receivables and commercial mortgage loans by selling them to special purpose enti- ties (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 on 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 establish legal isolation of the transferred loans. We often retain interests in securi- tized 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 sev- eral 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 activ- ities 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 We adopted the Canadian Institute of Chartered Accountants (CICA) Accounting Guideline 15, Consolidation of Variable Interest Entities (AcG-15) on November 1, 2004, which 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 to analyze and calculate its expected losses and its 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 sec- tion 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 retire- ment. 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, contribu- tions 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. 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 timing difference based on the future tax rates that are expected to be in effect and man- agement’s assumptions regarding the expected timing of the reversal of such temporary differences. Other-than-temporary impairment of investment securities Investments in equity and debt securities which are purchased for longer term purposes are classified as Investment account securities. These securities 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. Investment account equity securities, including non-public and venture capital equity securities for which representative market quotes are not readily available, are carried at cost. Investment account debt securities are carried at amortized cost. Debt and publicly traded equity investment securities are reviewed at each quarter-end to determine whether the fair value is below its car- rying value. Investments in private companies’ securities with carrying value greater than $5 million are reviewed semi-annually to determine whether the fair value is below its carrying value. All other strategic investments in equity securities are reviewed, at a minimum, on an annual basis to determine whether the fair value is below its carrying value. When the fair value of any of our Investment account securities has declined below its carrying value, management is required to assess whether the decline is other than temporary. In making this assessment, we consider factors such as the type of investment, the length of time and extent to which the fair value has been below the carrying value, 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 decisions to record a writedown, its amount and the period in which it is recorded could change if management’s assessment of those factors is different. As at October 31, 2006, total unrealized losses on Investment account securities for which the carrying value exceeded fair value were $294 million. Of this amount, $219 million was related to securities for which the carrying value had exceeded fair value for 12 months or more. During 2006, we recorded $24 million in Non-interest income on the Consolidated Statement of Income for the recognition of other-than-temporary impairment of Investment account securities. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 35 Hedges Section 3865 specifies the criteria under which hedge accounting can be applied and how hedge accounting should be executed for each of the permitted hedging strategies: fair value hedges, cash flow hedges and hedges of a foreign currency exposure of a net investment in a self-sustaining foreign operation. In a fair value hedging relationship, the carrying value of the hedged item will be adjusted by gains or losses attributable to the hedged risk and recognized in Net income. The change in the fair value of the hedged item, to the extent that the hedging relationship is effective, will be offset by changes in the fair value of the hedging derivative. In a cash flow hedging relationship, the effective portion of the change in the fair value of the hedging deriva- tive will be recognized in OCI. The ineffective portion will be recognized in Net income. The amounts recognized in AOCI will be reclassified to Net income in the periods in which Net income is affected by the vari- ability in the cash flows of the hedged item. 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 will be recognized in OCI and the ineffective portion is rec- ognized in Net income. For hedging relationships existing prior to adopting Section 3865 that are continued and qualify for hedge accounting under the new standard, the transaction accounting is as follows: (i) Fair value hedges – any gain or loss on the hedging instrument is recognized in the opening balance of retained earnings on transition and the carrying amount of the hedged item is adjusted by the cumulative change in fair value that reflects the designated hedged risk and the adjustment is included in the opening balance of retained earnings on transition; (ii) Cash flow hedges and hedges of a net investment in a self-sustaining foreign operation – any gain or loss on the hedging instrument that is determined to be the effective portion is recognized in AOCI and the ineffectiveness in the past periods is included in the opening balance of retained earnings on transition. Deferred gains or losses on the hedging instrument with respect to hedging relationships that were discontinued prior to the transition date but qualify for hedge accounting under the new standards will be recognized in the carrying amount of the hedged item and amortized to Net income over the remaining term of the hedged item for fair value hedges, and for cash flow hedges it will be recognized in AOCI and reclassified to Net income in the same period during which the hedged item affects Net income. However, for discontinued hedging relation- ships that do not qualify for hedge accounting under the new standards, the deferred gains and losses are recognized in the opening balance of retained earnings on transition. In October 2006, the CICA’s Accounting Standards Board issued a Board Notice, Hedges, Section 3865, in order to provide clarifying guidance with respect to the transition provisions for deferred gains or losses on continuing and discontinued hedging relationships. The amended version of Section 3865 incorporating the clarifying guidance is expected to be issued in December 2006, with early adoption permit- ted. We have adopted the proposed amendments on November 1, 2006. Future changes in accounting policies Financial Instruments In 2005, the CICA issued three new accounting standards: Handbook Section 1530, Comprehensive Income (Section 1530), Handbook Section 3855, Financial Instruments – Recognition and Measurement (Section 3855), and Handbook Section 3865, Hedges (Section 3865). These new standards became effective for us on November 1, 2006. Comprehensive Income Section 1530 introduces Comprehensive income which is comprised of Net income and Other comprehensive income and represents changes in Shareholders’ equity during a period arising from transactions and other events with non-owner sources. Other comprehensive income (OCI) includes unrealized gains and losses on financial assets classified as available-for-sale, unrealized foreign currency translation amounts, net of hedging, arising from self-sustaining foreign operations, and changes in the fair value of the effective portion of cash flow hedging instruments. Our Consolidated Financial Statements will include a Consolidated Statement of Comprehensive Income while the cumulative amount, Accumulated other comprehensive income (AOCI), will be presented as a new category of Shareholders’ equity in the 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 deriva- tives be recognized on the balance sheet when we become a party to the contractual provisions of the financial instrument or a non-financial derivative contract. All financial instruments should 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 liabilities. Financial assets and financial liabilities held-for-trading will be measured at fair value with gains and losses recognized in Net income. Financial assets held-to-maturity, loans and receivables and financial liabilities other than those held-for-trading, will be measured at amortized cost using the effective interest method of amortization. Available-for-sale financial assets will be 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 will be measured at cost. Derivative instruments must be recorded on the balance sheet at fair value including those derivatives that are embedded in financial instrument or other contracts but are not closely related to the host financial instrument or contract, respectively. Changes in the fair values of derivative instruments will be recognized in Net income, except for derivatives that are designated as a cash flow hedge, the fair value change for which will be recognized in OCI. Section 3855 permits an entity to designate any financial instrument as held-for-trading on initial recognition or adoption of the standard, even if that instrument would not otherwise satisfy the definition of held-for-trading set out in Section 3855. Instruments that are classified as held-for-trading by way of this “fair value option” must have reliable fair values and are subject to additional conditions and disclosure requirements set out by the OSFI. Other significant accounting implications arising on adoption of Section 3855 include the initial recognition of certain financial guar- antees at fair value on the balance sheet and the use of the effective interest method of amortization for any transaction costs or fees, premiums or discounts earned or incurred for financial instruments measured at amortized cost. Royal Bank of Canada Annual Report 2006 36 Management’s Discussion and Analysis Impact of adopting sections 1530, 3855 and 3865 The transition adjustment attributable to the following will be recog- nized in the opening balance of retained earnings as at November 1, 2006: (i) financial instruments that we will classify as held-for-trading and that were not previously recorded at fair value, (ii) the difference in the carrying amount of loans and deposits prior to November 1, 2006, and the carrying amount calculated using the effective interest rate from inception of the loan, (iii) the ineffective portion of cash flow hedges, (iv) deferred gains and losses on discontinued hedging relationships that do not qualify for hedge accounting under the new standards, (v) unamortized deferred net realized gains or losses on investments that support life insurance liabilities, and (vi) consequential effects on insurance claims and policy benefit liabilities due to remeasuring the financial assets supporting these liabilities. Adjustments arising due to remeasuring financial assets classified as available-for-sale and hedging instruments designated as cash flow hedges will be recognized in the opening balance of Accumulated other comprehensive income. 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 designated to ensure that information is accu- mulated and communicated to management, including the President and Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. As of October 31, 2006, an evaluation was carried out, under the supervision of and with the participation of management, including the President and Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Rule 13a-15(e) under the U.S. Securities Exchange Act of 1934 and under Multilateral Instrument 52-109. Based on that evalua- tion, the President and Chief Executive Officer and Chief Financial Officer concluded that the design and operation of our disclosure controls and procedures were effective as at October 31, 2006. Neither of the transition amounts that will be recorded in the open- ing retained earnings or in the opening AOCI balance on November 1, 2006 is expected to be material to our consolidated financial position. The tax consequences, if any, of the new standards on the transi- tion or subsequent accounting is unknown. The tax authorities are currently reviewing the standards to determine any such implications. Variability in Variable Interest Entities On September 15, 2006, the EIC issued Abstract No. 163, Determining the Variability to be Considered in Applying AcG-15 (EIC-163). This EIC provides additional clarification on how to analyze and consolidate VIEs. EIC-163 will be effective for us on February 1, 2007 and its implemen- tation will result in the deconsolidation of certain investment funds. However, the impact is not expected to be material to our consolidated financial position or results of operations. Internal control over financial reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assur- ance 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 at October 31, 2006, and based on that assess- ment determined that our internal control over financial reporting was effective. See page 101 for Management’s report on internal control over financial reporting and the Report of Independent Registered Chartered Accountants with respect to management’s assessment of internal control over financial reporting. No changes were made in our internal control over financial reporting during the year ended October 31, 2006, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 37 Consolidated results from continuing operations • • • Net income of $4,757 million, up $1,320 million, or 38%. Excluding the prior year Enron litigation-related provision (1) of $326 million after-tax, net income increased $994 million, or 26%, largely due to strong earnings momentum across all business segments and lower hurricane-related charges. Revenue up $1,453 million, or 8%, from 2005 due to record trading results on improved market conditions and solid business growth in our wealth management and banking businesses. Non-interest expense up $138 million, or 1%. Excluding the prior year Enron litigation-related provision of $591 million, non-interest expense increased $729 million, or 7%, primarily due to higher variable compensation on stronger business performance. The following provides a discussion of our reported results from continuing operations for the year ended October 31, 2006. Factors that primarily relate to a specific segment are discussed in detail in the respective segment results section. For a discussion of our discontinued operations, refer to the Executive summary section. In addition to providing an analysis comparing the current year to the prior year, we have included an analysis of our 2005 results com- pared to those for 2004. Total revenue (C$ millions) Interest income Interest expense Net interest income Investments (1) Insurance (2) Trading Banking (3) Underwriting and other advisory Other (4), (5) Non-interest income Total revenue Additional information Total trading revenue (6) Net interest income – related to trading activities Non-interest income – trading revenue Total Total trading revenue by product (6) Fixed income and money markets Equity Foreign exchange contracts Total 2006 2005 Table 7 2004 $ 22,170 15,408 $ 16,958 10,188 $ 13,866 7,468 $ $ $ $ 6,762 3,820 3,348 2,574 2,391 1,024 718 $ $ 6,770 3,380 3,270 1,594 2,326 1,026 818 6,398 3,142 2,870 1,563 2,173 918 738 $ 13,875 $ 12,414 $ 11,404 $ 20,637 $ 19,184 $ 17,802 $ $ $ (539) $ 2,574 21 1,594 $ 286 1,563 2,035 $ 1,615 $ 1,849 $ 1,174 561 300 $ 1,025 355 235 1,044 527 278 $ 2,035 $ 1,615 $ 1,849 Includes brokerage, investment management and mutual funds. Includes premiums, investment and fee income. Includes service charges, foreign exchange other than trading, card services and credit fees. Includes other non-interest income, gain/loss on securities sales and securitization. (1) (2) (3) (4) (5) During the year, we reclassified the changes in the fair value of certain derivative instruments designated as economic hedges of our stock-based compensation plan at RBC Dain Rauscher from Non-interest income – Other to Non-interest expense – Stock-based compensation, in order to more appropriately reflect the purpose of these instruments and our management of our compen- sation plan. All amounts have been restated to reflect this reclassification. For further details, refer to Note 1 to the Consolidated Financial Statements. Total trading revenue is comprised of trading-related revenue recorded in Net interest income and Non-interest income. Total trading revenue includes revenue from cash and related derivative securities. (6) 2006 vs. 2005 Total revenue increased $1,453 million, or 8%, from a year ago, largely due to record trading results on improved market conditions and solid business growth in our wealth management and banking businesses reflecting our successful execution of 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 translated U.S. dollar-denominated revenue, lower debt and equity origination activity and certain favourable items recorded in the prior year. These items included 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 sale of LIS. Net interest income decreased $8 million, largely driven by increased funding costs related to certain equity trading strategies and the impact of higher securitization balances. This decrease was largely offset by strong loan and deposit growth and increased spreads on deposits and personal investment products. Investments-related revenue increased $440 million, or 13%, primarily due to strong net sales and capital appreciation in our mutual fund businesses, growth in fee-based accounts and client balances, the inclusion of Abacus and higher volumes in our full-service and self- directed brokerage businesses. Insurance-related revenue increased $78 million, or 2%, primarily reflecting growth in our Canadian life business as well as our 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 on the translated value of U.S. dollar-denominated revenue resulting from the stronger Canadian dollar and policy lapses on discontinued and mature product lines. Lower revenue from property catastrophe reinsurance reflecting our strategic reduction in exposure as we have ceased underwriting new business also contributed to the decrease. Banking revenue was up $65 million, or 3%, mainly due to higher service fees, higher credit fees related to our investment banking activ- ity and increased foreign exchange revenue due to higher transaction volume. These factors were partially offset by our higher credit card cus- tomer loyalty reward program costs that were recorded against revenue. (1) Results excluding the Enron litigation-related provision are non-GAAP financial measures. For a further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Royal Bank of Canada Annual Report 2006 38 Management’s Discussion and Analysis Trading revenue increased by $980 million, or 61%. Total trading Net interest income increased $372 million, or 6%, largely driven revenue (including Net interest income and Non-interest income related to trading) 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 the prior year including the gain on the sale of an Enron-related claim, a cumulative accounting adjust- ment 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 both recorded in 2006. 2005 vs. 2004 Total revenue in 2005 increased $1,382 million, or 8%, compared to 2004, reflecting revenue growth across all lines of business in part due to our growth initiatives and favourable North American business conditions. These factors resulted in increased revenue from our lend- ing, deposit, insurance and wealth management businesses. The increase was partially offset by a reduction of $420 million due to the negative impact of the stronger Canadian dollar on translated U.S. dollar- denominated revenue. by increased loan and deposit volumes in both Canada and the U.S., partially offset by increased funding costs as a result of higher volumes and rates on funding positions related to equity trading. Investments-related revenue increased $238 million, or 8%, primarily due to higher transaction volumes and growth in client assets in our full-service brokerage business and strong mutual fund sales and capital appreciation. Insurance-related revenue increased $400 million, or 14%, reflect- ing growth in our disability insurance business, which has included UnumProvident since May 1, 2004, as well as strong growth in our prop- erty and casualty, life and reinsurance businesses. This was partially offset by the effect of the sale of LIS in 2005. Banking revenue increased $153 million, or 7%, mainly due to increased foreign exchange revenue and higher service fees. Trading revenue improved $31 million, or 2%. Total trading rev- enue (including Net interest income and Non-interest income related to trading) was $1,615 million, down $234 million, or 13%, from a year ago across all product categories but primarily in our equity trading business largely due to challenging market conditions for most of 2005. Underwriting and other advisory revenue increased $108 million, or 12%, on higher debt originations due to a historically low interest rate environment and higher equity originations arising from strength in income trust and structured products. Other revenue increased $80 million, or 11%, largely due to the gain on the sale of an Enron-related claim, higher securitization revenue and higher private equity gains, which were partially offset by the gain on the sale of real estate in 2004. Net interest income and margin (C$ millions, except percentage amounts) Net interest income Average assets (1) Net interest margin (2) 2006 2005 Table 8 2004 $ 6,762 502,100 $ 6,770 445,300 $ 6,398 418,200 1.35% 1.52% 1.53% (1) (2) Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Net interest income as a percentage of average assets. 2006 vs. 2005 Net interest margin decreased 17 bps reflecting both lower net interest income and an increase in lower yielding and non-interest earning assets. The decrease in net interest income compared to the prior year primarily reflected higher funding costs in support of growth in certain equity trading strategies which was partially offset by stronger loan and deposit growth and increased spreads on deposits and personal invest- ment products. We experienced higher growth and activity 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 Tables 56 and 57 in the Additional financial information section. 2005 vs. 2004 Net interest margin decreased 1 bp, largely reflecting higher funding costs in RBC Capital Markets in support of their trading activities. This decrease was partially offset by net interest margin improvement in RBC U.S. and International Personal and Business largely due to strong loan growth relative to other assets, which earn lower returns. Non-interest expense (C$ millions) Salaries Variable compensation Stock-based compensation (1) Benefits and retention compensation Human resources Equipment Occupancy Communications Professional and other external services Other expenses Non-interest expense $ $ 2006 3,264 2,827 169 1,080 7,340 957 792 687 926 793 $ $ 2005 3,155 2,309 169 1,103 $ 6,736 $ 960 749 632 825 1,455 Table 9 2004 3,199 2,283 124 1,095 6,701 906 765 672 768 1,021 $ 11,495 $ 11,357 $ 10,833 (1) During the year, we reclassified the changes in the fair value of certain derivative instruments designated as economic hedges of our stock-based compensation plan at RBC Dain Rauscher from Non-interest income – Other to Non-interest expense – Stock-based compensation, in order to more appropriately reflect the purpose of these instruments and our management of our compen- sation plan. All amounts have been restated to reflect this reclassification. For further details, refer to Note 1 to the Consolidated Financial Statements. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 39 2006 vs. 2005 Non-interest expense increased $138 million, or 1%, compared to the prior year. Excluding the Enron provision, non-interest expense increased $729 million, or 7%, which largely reflected higher variable compensation primarily in RBC Capital Markets and our wealth manage- ment businesses reflecting strong business performance. Higher costs in support of our growth initiatives also contributed to the increase. These costs reflected a higher level of sales personnel and infrastructure in our distribution network, increased costs related to systems applica- tion development, higher marketing and advertising costs, and a larger number of branches. The increase in non-interest expense was partially offset by the $215 million reduction in the translated value of U.S. dollar- denominated expenses due to the stronger Canadian dollar and the prior year settlement of the Enron MegaClaims bankruptcy lawsuit. Non-interest expense excluding the prior year Enron provision is a non-GAAP measure. For a reconciliation and further discussion, refer to the Key financial measures (non-GAAP) section. 2005 vs. 2004 Non-interest expense increased $524 million, or 5%, from 2004, largely reflecting the prior year Enron provision of $591 million. Stock-based compensation was also higher in light of the significant appreciation in our common share price in 2005. Increased costs related to the higher level of sales and service personnel in our Canadian branch network also contributed to the increase. These factors were partially offset by a $260 million decline in expenses due to the positive impact of the stronger Canadian dollar on the translation of U.S. dollar-denominated expenses and improved productivity reflecting cost-reduction efforts attributable to streamlining head office and support operations, procurement initiatives and lower occupancy costs as a result of optimizing our office space. The prior year also included the Rabobank settlement costs. Provision for credit losses (C$ millions) Residential mortgages Personal Credit cards Consumer Business and government Specific provision General provision Provision for credit losses Table 10 2006 2005 2004 $ $ $ 6 306 163 475 7 482 (53) $ $ $ 2 259 194 455 (66) 389 66 7 222 167 396 125 521 (175) 429 $ 455 $ 346 $ $ $ $ 2006 vs. 2005 Total provision for credit losses decreased $26 million, or 6%, from a year ago. The decrease largely reflected a $50 million reversal of the general allowance this year, the favourable impact of the higher level of securitized credit cards, and the continued strong credit quality of our U.S. loan portfolio. The prior year also included our 50% proportionate share of a provision booked at 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 portfolios. Specific provision for credit losses for consumer loans was up $20 million, or 4%, compared to the previous year. The increase was largely due to higher provisions in Canadian personal loans in part reflecting portfolio growth, which was partly offset by the favourable impact of the higher level of securitized credit cards. Business and government provision for credit losses increased $73 million over the prior year. The increase primarily reflected the transfer of $52 million from the specific allowance to the general allow- ance in the prior year as a result of the alignment of our enterprise-wide accounting treatment of credit losses, lower recoveries in our corporate and agriculture portfolios, and higher provisions in small business loans in the current year. These factors were partially offset by a lower provision in our U.S. business portfolio reflecting continued strong credit quality. The prior year included our 50% proportionate share of a provision booked at Moneris. The general provision decreased $119 million from a year ago. The decrease was largely due to a $50 million reversal of the general allowance this year in light of the strengthening of our corporate loan portfolio reflecting continuing favourable credit conditions, and the transfer of $52 million from the specific allowance to the general allow- ance in the prior year. 2005 vs. 2004 Total provision for credit losses increased $109 million, or 32%, from 2004. The increase was mainly due to the $175 million reversal of the general allowance in 2004 and higher specific provisions in personal credit lines and credit cards mainly due to portfolio growth in 2005. The increase was partially offset by higher corporate recoveries and lower student loan losses in 2005. Insurance policyholder benefits, claims and acquisition expense (C$ millions) Insurance policyholder benefits, claims and acquisition expense Table 11 2006 2005 2004 $ 2,509 $ 2,625 $ 2,124 2006 vs. 2005 Insurance policyholder benefits, claims and acquisition expense decreased $116 million, or 4%, compared to the prior year. The decrease primarily reflected a $142 million (before- and after-tax) reduction in hurricane-related charges for estimated 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 this year. Royal Bank of Canada Annual Report 2006 40 Management’s Discussion and Analysis 2005 vs. 2004 Insurance policyholder benefits, claims and acquisition expense increased $501 million, or 24%, over 2004 largely reflecting higher busi- ness volumes in the disability insurance business, which has included UnumProvident since May 1, 2004, and charges for estimated net claims for damages related to hurricanes Katrina, Rita and Wilma. Net increases in life insurance liabilities reflecting decreases in long-term interest rates, a change in the tax treatment of certain invested assets, and higher policy maintenance costs also contributed to the increase. These items were partially offset by a net decrease in health insurance reserves due to improved disability claims and termination experience. Taxes (C$ millions, except percentage amounts) Income taxes Other taxes Goods and services and sales taxes Payroll taxes Capital taxes Property taxes (1) Insurance premium taxes Business taxes Total Effective income tax rate (2) Effective total tax rate (3) $ $ Table 12 2006 2005 2004 1,403 $ 1,278 $ 1,287 $ 218 217 107 92 39 7 680 $ 218 220 164 93 39 9 743 225 207 140 84 33 13 702 $ 2,083 $ 2,021 $ 1,989 22.6% 30.3% 27.2% 37.1% 29.8% 39.6% (1) (2) (3) Includes amounts netted against non-interest income regarding investment properties. Income taxes as a percentage of net income before income taxes. 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. $136 million in 2006 (2005 – $220 million) in Shareholders’ equity, a reduction of $84 million, reflecting a decrease in unrealized foreign currency translation gains as shown in Note 24 to our Consolidated Financial Statements. 2006 vs. 2005 As shown in Table 12 above, income taxes are up from last year, largely reflecting higher earnings and the impact of the $591 million ($326 mil- lion after-tax) Enron litigation-related provision recorded in the prior year. The effective income tax rate for the year decreased 4.6% primarily due to higher income reported by our international subsidiaries that operate in lower income tax jurisdictions, 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 by $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. In addition to the income and other taxes reported in the Consolidated Statements of Income, we recorded income taxes of 2005 vs. 2004 Income taxes were relatively unchanged compared to 2004, despite higher income before income taxes from continuing operations. Higher income reported by our international subsidiaries that operated in lower income tax jurisdictions, additional income from tax-advantaged sources, and a tax recovery resulting from the Enron litigation provision had the effect of lowering our effective tax rate by 2.6% to 27.2% com- pared to 2004. Other taxes increased by $41 million, largely due to an increase in capital and payroll taxes as a result of higher capital levels and busi- ness growth. In addition to the income and other taxes reported in the Consolidated Statements of Income, we recorded income taxes of $220 million in 2005 ($330 million in 2004) in Shareholders’ equity, a reduction of $110 million, reflecting a decrease in unrealized foreign currency translation gains as shown in Note 24 to our Consolidated Financial Statements. Business realignment charges Table 13 (C$ millions) Employee-related Other Total business realignment charges from continuing operations $ $ Expense for the year ended October 31 2006 2005 $ – – $ 45 – Liability balance as at October 31 2004 164 13 2006 $ $ 41 2 2005 118 – $ 2004 164 13 – $ 45 $ 177 $ 43 $ 118 $ 177 In 2006, we continued to implement the additional cost-reduction activi- ties identified during 2005. However, we did not record any additional business realignment charges for continuing operations. The charges incurred in the prior year primarily related to the net additional positions identified for elimination. The business realignment liability from continuing operations decreased by a net of $75 million from the prior year largely reflecting employee-related payments for income-protection and professional fees. Although the majority of our realignment initiatives were completed by the end of 2006, certain payments related to income-protection and certain lease obligations will continue. For additional details, refer to Note 23 to our Consolidated Financial Statements. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 41 Results by geographic segment (1), (2) Table 14 2006 2005 2004 (C$ millions) Canada United Other States International Total Canada United Other States International Total Canada United Other States International Total Net interest income Non-interest income $ 6,011 7,552 $ 108 4,397 $ 643 1,926 $ 6,762 13,875 $ 5,605 6,901 $ 608 3,955 $ 557 1,558 $ 6,770 12,414 $ 5,011 6,121 $ 934 3,743 $ 453 1,540 $ 6,398 11,404 Total revenue Provision for (recovery of) credit losses Insurance policyholder benefits, claims and acquisition expense Non-interest expense Business realignment charges Income taxes and non-controlling interest 13,563 4,505 2,569 20,637 12,506 4,563 2,115 19,184 11,132 4,677 1,993 17,802 456 (28) 1 429 433 23 (1) 455 343 61 (58) 346 1,379 7,056 – 683 3,038 447 1,401 2,509 11,495 1,270 6,685 45 809 3,595 – 546 1,077 – 2,625 11,357 45 909 6,395 142 872 3,457 29 343 981 6 2,124 10,833 177 1,495 13 (61) 1,447 1,299 (64) 30 1,265 1,172 46 81 1,299 Net income from continuing operations Net income (loss) from discontinued operations Net income $ 3,177 $ 799 $ 781 $ 4,757 $ 2,774 $ 200 $ 463 $ 3,437 $ 2,171 $ 212 $ 640 $ 3,023 $ – $ 3,177 $ $ (29) $ – $ (29) $ – 770 $ 781 $ 4,728 $ 2,774 $ $ (50) $ – $ (50) $ – 150 $ 463 $ 3,387 $ 2,171 $ $ (220) $ – $ (220) (8) $ 640 $ 2,803 (1) (2) 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. Certain consolidated and segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. 2005 vs. 2004 Net income in Canada was $2,774 million, up $603 million, or 28%, from 2004. This increase reflected growth in our banking and wealth management businesses, and volume growth in our disability insurance business as a result of the acquisition of UnumProvident. These factors were partly offset by higher non-interest expense, largely reflecting higher levels of sales and service personnel in our Canadian distribution network, higher benefit costs and higher advertising and new program costs in support of business growth. The provision for credit losses increased $90 million, which largely reflected the reversal of the general allowance in 2004. U.S. net income of $150 million in 2005 compared to a net loss of $8 million in 2004. U.S. net income from continuing operations of $200 million in 2005 compared to net income of $212 million in 2004. Net income from continuing operations in 2005 largely reflected the Enron litigation provision recorded and the negative impact of the stron- ger Canadian dollar on the translated value of U.S. dollar-denominated earnings. These factors were partially offset by reductions in non-interest expense related to Client First and lower provision for credit losses reflecting improved credit conditions. Also, 2004 included the Rabobank settlement costs. Net loss from discontinued operations of $50 million in 2005 compared to a net loss of $220 million in 2004. The net loss in 2005 reflected charges related to the sale and wind-down of operations, including the costs of closing RBC Mortgage’s Chicago office and certain branches, employee incentive payments and the writedown of certain assets. The net loss in 2004 of $220 million largely reflected the $130 million goodwill impairment charge related to RBC Mortgage. Other international net income was down $177 million, or 28%, from 2004, mainly reflecting the $203 million charges for estimated net claims from hurricanes Katrina, Rita and Wilma. 2006 vs. 2005 Net income in Canada was $3,177 million, up $403 million, or 15%, compared to the prior year. This increase largely reflected strong revenue growth in our wealth management and banking businesses due to our successful execution of growth initiatives and the continuing favourable economic conditions. Stronger M&A activity also contrib- uted to the increase. 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 is comprised of 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 the prior year largely reflecting the prior year Enron provision and strong trading results in the current period. 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 com- pared to a net loss of $50 million in the prior year. The current period net loss reflected charges related to the wind-down of operations of RBC Mortgage. The prior year net loss largely reflected charges related to the sale of certain assets and wind-down of operations, including the costs of closing RBC Mortgage’s Chicago office and certain branches, employee incentive payments and the writedown of certain assets. Other international net income was up $318 million, or 69%, from 2005, mainly reflecting the $142 million reduction in net estimated hurricane-related charges, as we recorded $203 million in the prior year related to hurricanes Katrina, Rita and Wilma and $61 million for additional claims in the current period predominantly related to Hurricane Wilma, 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 21 to our Consolidated Financial Statements. Royal Bank of Canada Annual Report 2006 42 Management’s Discussion and Analysis Quarterly financial information Results and trend analysis Our quarterly earnings, revenue and expense are impacted by a number of trends and recurring factors which include seasonality, general economic conditions and competition. Seasonality Seasonal factors impact our results in most quarters. The second quarter has fewer days than the other three quarters, resulting in a decrease in individual revenue and 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, broker- age and investment management businesses. Impact of economic and market conditions In general, economic conditions remained favourable over the past eight quarters and positively impacted our businesses. A relatively solid housing market, a low but rising interest rate environment, strong labour markets conditions, as well as solid consumer and business spending supported loan and deposit growth and strong demand for our wealth management products over the period. These favourable factors, along with our continued risk management efforts, contributed to a general improvement in our portfolio credit quality. In general, capital market conditions were more favourable in 2006 compared to the prior year, characterized by higher equity market volatility, near record high M&A activity and solid cash equities business which benefited from healthy foreign demand for Canadian natural resource-based equities. Partly offsetting these favourable factors was the strengthening of the Canadian dollar over the period, which resulted in a lower translated value of our U.S. dollar- and GBP-denominated earnings, primarily in our wholesale and U.S. retail operations. In addition, heightened market competition in both Canadian and U.S. lending products resulted in spread compression. There was also increased competition in wholesale banking, as U.S.-based investment banks expanded their presence in Canada after the elimination of foreign content restrictions on Canadian registered retirement products. The following table summarizes our results for the last eight quarters. Quarterly results (1) Table 15 (C$ millions, except per share amounts) Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 2006 2005 Net income from continuing operations Net income (loss) from discontinued operations 1,263 (1) 1,194 (17) 1,128 (10) 1,172 (1) 19 44 (25) 6 Net interest income Non-interest income Total revenue Non-interest expense Provision for credit losses Insurance policyholder benefits, claims and acquisition expense Business realignment charges Net income before income taxes and non-controlling interest in subsidiaries Income taxes Non-controlling interest in net income of subsidiaries Net income Earnings per share (2) – basic – diluted Earnings per share (2) from continuing operations – basic – diluted Segment net income (loss) from continuing operations RBC Canadian Personal and Business RBC U.S. and International Personal and Business RBC Capital Markets Corporate Support $ 1,721 3,628 $ 5,349 2,955 159 $ 1,757 3,449 $ 5,206 2,861 99 $ 1,609 3,513 $ 5,122 2,928 124 $ 1,675 3,285 $ 4,960 2,751 47 $ 1,757 3,039 $ 4,796 3,310 103 $ 1,657 3,272 $ 4,929 2,732 128 $ 1,662 3,024 $ 4,686 2,661 116 $ 1,694 3,079 $ 4,773 2,654 108 611 – 627 – 619 – 652 – 740 40 681 1 622 2 582 2 $ 1,624 342 $ 1,619 381 $ 1,451 348 $ 1,510 332 $ 603 90 $ 1,387 392 $ 1,285 353 $ 1,427 443 $ 1,262 $ 1,177 $ 1,118 $ 1,171 $ $ $ $ .97 .96 .97 .96 $ $ $ $ .91 .90 .92 .91 $ $ $ $ .86 .85 .87 .86 $ $ $ $ .90 .89 .90 .89 $ $ $ $ $ (30) 543 (21) 522 .40 .39 .42 .41 (6) 1,001 (22) $ $ $ $ $ 979 .75 .74 .77 .76 $ $ $ $ $ 16 916 (9) 907 .70 .69 .71 .70 $ $ $ $ $ 7 977 2 979 .76 .75 .76 .75 $ 775 $ 742 $ 608 $ 669 $ 504 $ 679 $ 524 $ 597 126 315 47 111 329 12 106 433 (19) 101 330 72 132 (57) (36) 80 255 (13) Net income from continuing operations $ 1,263 $ 1,194 $ 1,128 $ 1,172 Period average USD equivalent of C$1.00 (3) Period-end USD equivalent of C$1.00 $ .897 .890 $ .896 .884 $ .877 .894 $ .865 .878 $ $ 543 $ 1,001 .850 .847 $ .810 .817 $ $ (1) (2) (3) Certain consolidated and segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. On April 6, 2006, we paid a stock dividend of one common share on each of our issued and outstanding common shares. The effect is the same as a two-for-one split of our common shares. All earnings per share calculations have been retroactively adjusted to reflect the stock dividend. Average amounts are calculated using month-end spot rates for the period. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 43 82 294 16 916 .811 .795 93 268 19 977 .827 .806 $ $ Trend analysis Overview Over the last eight quarters, our results were affected by a number of favourable and unfavourable specified items. In the first quarter of 2006 and the fourth quarter of 2005, our results were impacted by $61 million (before- and after-tax) and $203 million (before- and after-tax), respectively, of hurricane-related charges in our insurance business. In the fourth quarter of 2005, we recorded a $591 million ($326 million after-tax) provision for Enron litigation-related matters. A $50 million reversal of the general allowance was recorded in the first quarter of 2006 in light of the strengthening of our corporate loan port- folio reflecting continuing favourable credit conditions. Our results were also impacted by the acquisition and disposition of certain businesses. We recorded an additional $40 million business realignment charge for continuing operations in the fourth quarter of 2005. In addition, RBC Mortgage was classified as discontinued operations in the second quarter of 2005 and certain assets of RBC Mortgage were sold in the fourth quarter of 2005. Consolidated results Our consolidated net income from continuing operations throughout 2006 was consistently higher than the prior year. This largely reflected a general increase in revenue across all our business segments. This posi- tive trend was partially offset by the lower translated value of foreign currency-denominated revenue and earnings as a result of the strength- ening of the Canadian dollar over the period. Non-interest expense increased over the period, largely reflecting increased variable compensation on strong business performance and higher costs in support of our growth initiatives, except for the fourth quarter of 2005, when we recorded a provision for Enron. The increase was partially offset by a reduction in the translated value of U.S. dollar- denominated expenses due to the strengthening of the Canadian dollar over the period. Provision for credit losses fluctuated slightly over the period. The decrease in provisions in the first quarter of 2006 was primarily due to a $50 million reversal of the general allowance discussed earlier. The fourth quarter of 2006 was impacted by higher provisions for personal and small business loans along with lower corporate recoveries. Corporate and commercial recoveries had positively impacted our business results over the period. Income taxes generally trended downward over the period, despite higher earnings before income taxes from continuing operations. This largely reflected higher earnings reported by our foreign subsidiaries operating in lower income tax jurisdictions, higher income from tax- advantaged sources (Canadian taxable corporate dividends) and the favourable resolution of an income tax audit in the first quarter of 2006. These factors contributed to a reduction in our effective income tax rate over the last eight quarters from 31.0% to 21.1%. 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 RBC Canadian Personal and Business net income generally increased over the last eight quarters. This reflected strong volume growth across most business lines and generally improved margins, despite strong market competition and a shift in client preferences towards lower spread products. RBC U.S. and International Personal and Business results largely trended upward over the period. This was primarily driven by solid revenue growth, albeit partly restrained by the negative impact on the translated value of U.S. dollar-denominated earnings due to the stronger Canadian dollar. RBC Capital Markets recorded a general improvement in earnings over the period, with the exception of the fourth quarter of 2005, which included the $591 million ($326 million after-tax) provision for Enron litigation-related matters. Our diverse business and product offerings, together with business expansions and growing global distribution capabilities, contributed to this positive trend. In addition, income taxes trended downward, despite increased earnings before tax, largely due to higher earnings reported by our international subsidiaries operating in lower tax jurisdictions. However, these factors were partially offset by the lower translated value of U.S. dollar- and GBP-denominated earnings resulting from the stronger Canadian dollar. Royal Bank of Canada Annual Report 2006 44 Management’s Discussion and Analysis Fourth quarter 2006 performance Fourth quarter net income of $1,262 million was up $740 million, or 142%, from a year ago. Diluted EPS were $.96, up 146%. ROE was 23.9%. The increase largely reflected the impact of the prior year provi- sion of $591 million ($326 million after-tax) related to Enron litigation matters. Excluding the prior year Enron provision, net income increased $414 million, or 49%. Continuing operations Net income from continuing operations of $1,263 million increased $720 million, or 133%, compared to the prior year and diluted EPS were up $.55, or 134%. ROE was 23.6%. Excluding the prior year Enron provision, net income increased $394 million, or 45%, and diluted EPS were up $.30, or 45%. The increase was primarily due to stronger revenue growth in our wealth management and banking businesses reflecting our successful execution of growth initiatives, and stronger trading results in our capital markets businesses. The reduction in our effective income tax rate in the current year and the prior year charge related to estimated net claims for damages related to hurricanes also contributed to the improvement in our results. These factors were partially offset by higher variable compensation reflecting stronger busi- ness performance, higher costs related to our ongoing initiatives and investments to support growth and higher provision for credit losses. Total revenue increased $553 million, or 12%, from a year ago, reflecting solid revenue growth in our wealth management and banking businesses and stronger trading results. Higher M&A activity and solid business growth in our European life reinsurance businesses also contributed to the increase. These factors were partly offset by the prior year gain on the sale of an Enron-related claim and lower debt and equity origination activity in the current period. Business segment results from continuing operations Non-interest expense decreased $355 million, or 11%, from a year ago, largely reflecting the prior year Enron provision. Excluding the Enron provision, non-interest expense was up $236 million, or 9%, largely reflecting higher variable compensation on stronger business performance. Higher staffing levels in our distribution network, as well as increased marketing and advertising costs in support of our business growth also contributed to the increase. Provision for credit losses increased $56 million from a year ago, largely reflecting lower recoveries in our corporate and agriculture port- folios in the current quarter and increased provisions in our personal loan and small business portfolios. Insurance policyholder benefits, claims and acquisition expense decreased $129 million, or 17%, over the prior year. The decrease largely reflected a charge of $203 million (before- and after-tax) related to estimated net claims for damages related to hurricanes Katrina, Rita and Wilma, which was partially offset by a net reduction in actuarial liabilities of $74 million, both of which were recorded in the prior period. Discontinued operations The net loss of $1 million in the fourth quarter of 2006 compared to a net loss of $21 million a year ago, which reflected an operating loss prior to the sale of certain assets of RBC Mortgage to Home123 Corporation on September 2, 2005, as well as charges related to the sale and wind- down of operations. As at October 31, 2006, we have substantially disposed of the assets and obligations related to RBC Mortgage that were not transferred to Home123 Corporation. Results by business segment (1) (C$ millions) Net interest income Non-interest income Total revenue Non-interest expense Provision for (recovery of) credit losses Insurance policyholder benefits, claims and acquisition expense Business realignment charges RBC Canadian Personal and Business RBC U.S. and International Personal and Business 2006 RBC Capital Markets (2) Table 16 2005 2004 Corporate Support (2) Total Total Total $ 5,941 $ 1,109 $ 201 $ 7,440 1,763 4,492 $ 13,381 $ 2,872 $ 4,693 $ 2,260 26 3,058 (115) 6,140 604 (489) $ 6,762 $ 6,770 $ 6,398 11,404 180 12,414 13,875 (309) $ 20,637 $ 19,184 $ 17,802 10,833 346 11,357 455 11,495 429 37 (86) 2,509 – – 1 – (1) – – 2,509 – 2,625 45 2,124 177 Net income before income taxes and non-controlling interest in net income of subsidiaries Net income from continuing operations $ 4,128 $ $ 2,794 $ 585 $ 1,751 $ 444 $ 1,407 $ (260) $ 6,204 $ 4,702 $ 4,322 112 $ 4,757 $ 3,437 $ 3,023 Return on equity (ROE) (3) Return on risk capital (RORC) (3) Average assets (4) 31.5% 43.1% 13.6% 22.4% $ 200,700 $ 39,000 $ 267,800 $ 29.3% 37.7% 3.0% n.m. 16.8% 26.5% (5,400) $ 502,100 $ 445,300 $ 418,200 23.3% 37.0% 18.1% 29.7% (1) (2) Certain consolidated and segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. Reported amounts include securitized residential mortgage and credit card loans. For further discussion, refer to the How we manage our business segments section. Net interest income, total revenue and net income before income taxes are presented in RBC 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 manage our business segments section. Average risk capital and the Return on risk capital are non-GAAP financial measures. For further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. (3) (4) n.m. not meaningful Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 45 RBC Canadian Personal and Business Net income of $2,794 million increased $490 million, or 21%, from a year ago. The increase largely reflected strong revenue growth in our banking and wealth management businesses and lower hurricane- related charges this year. The increase was partly offset by higher variable compensation on stronger business performance, increased costs in support of business growth and higher provision for credit losses partly due to loan growth and lower recoveries. RBC U.S. and International Personal and Business Net income of $444 million was up $57 million, or 15%, from the prior year, despite a $28 million reduction due to the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated earnings. In U.S. dollars, net income was up US$73 million, or 23%, driven by strong revenue growth in Wealth Management and solid business growth and improved credit quality in Banking. RBC Capital Markets Net income was $1,407 million, up $647 million, or 85%, compared to a year ago, mostly reflecting the prior year Enron provision and record trading results in the current period. Excluding the prior year Enron pro- vision, net income increased $321 million, or 30%, compared to a year ago largely reflecting 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, lower debt and equity origination activity and the negative impact of a stronger Canadian dollar on the translated value of our U.S. dollar- and GBP-denominated earnings. Corporate Support Net income of $112 million for the year mainly reflected income tax amounts which were largely related to enterprise funding activities and the favourable resolution of income tax audits related to prior years not allocated to the business segments. Mark-to-market gains on deriva- tives related to certain economic hedges also contributed to net income in the year. These factors were partially offset by the timing of securitiza- tion activity and an amount accrued for lease obligations. Revenue contribution from our business segments (C$ millions) Net income contribution from our business segments (C$ millions) 25,000 20,000 15,000 10,000 5,000 0 RBC Capital Markets RBC U.S. and International Personal and Business RBC Canadian Personal and Business 5,000 4,000 3,000 2,000 1,000 0 2004 2005 2006 2004 2005 2006 RBC Capital Markets RBC U.S. and International Personal and Business RBC Canadian Personal and Business How we manage our business segments 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 the business segments are managed. This approach is intended to ensure that our business segment results reflect all relevant revenue and expenses associated with the conduct of their business and depicts how management views their results. We use and report certain non-GAAP financial measures, consistent with our management framework. These measures do not have standardized meanings under GAAP and are not necessarily comparable with similar information reported by other financial institutions. The following highlights how our segments are managed and reported: • RBC Canadian Personal and Business reported results include securitized 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, 2006 were $17.8 billion and $3.7 billion, respectively. RBC U.S. and International Personal and Business reported results include additional disclosure in U.S. dollars as we largely review and manage the results of this segment on a U.S. dollar basis. RBC Capital Markets results are reported on a teb basis, which grosses up net interest income from certain tax-advantaged sources (Canadian taxable corporate dividends) to their effective tax equivalent value with a corresponding offset recorded in the provision for income taxes. This enhances the comparability of revenue and related ratios across our taxable and tax-advantaged sources of revenue. Corporate Support results include all enterprise level activities that are undertaken for the benefit of the organization which are not • • • Royal Bank of Canada Annual Report 2006 46 Management’s Discussion and Analysis allocated to our three business segments, such as enterprise fund- ing, 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 RBC Capital Markets. Key methodologies The following outlines the key methodologies and assumptions used in our management reporting framework. These assumptions and meth- odologies are periodically reviewed by management to ensure that they remain valid. Expense allocation In order to ensure that our segments’ results include expenses associ- ated with the conduct of their business, we allocate costs incurred or services provided by our Global Technology and Operations and Global Functions groups, which were directly undertaken or provided on behalf of the segments. 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 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 consistently measures and aligns economic costs with the underlying benefits and risks associated with the activi- ties of each business segment. The amount of capital assigned to each segment is referred to as Attributed equity. Unattributed equity and associated net charges are reported in Corporate Support. The capital attribution methodologies, detailed in the Capital man- agement section of this Annual Report, involve a number of assumptions and estimates that are revised periodically. Any changes to these factors directly impact other measures such as our business segments’ return on average 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. This allocation considers the interest rate risk, liquidity risk and regulatory requirements of our business segments. Our 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 (in our case, Canadian taxable corporate dividends) on a taxable equivalent basis (teb). Under this approach, we gross up revenue from tax-advantaged sources, which currently includes only our Canadian taxable corporate dividends recorded in Net interest income, to their tax equivalent value with a corresponding offset recorded in the provision for income taxes. We record teb adjustments in RBC Capital Markets and record elimination adjustments in Corporate Support. We believe these adjustments are useful and reflect how RBC Capital Markets manages its business since it enhances the comparability of revenue and related ratios across our taxable and 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 adjustments for 2006 were $213 million (2005 – $109 million; 2004 – $55 million). Changes made in 2006 The following highlights the key changes we made to our management reporting framework and business segments during the year. All seg- ment historical comparatives have been restated for 2005 and 2004. These changes did not have an impact on our consolidated results or disclosure, unless otherwise noted. • We enhanced our transfer pricing methodologies. • We recorded the teb adjustments, which gross up tax-advantaged income, currently Canadian taxable corporate dividends, to their Key financial measures (non-GAAP) tax equivalent value, in RBC Capital Markets, and eliminated the teb adjustments in Corporate Support. • We reported segment net interest margin (NIM) based on earning assets only. Previously, we reported segment NIM based on Total average assets. This change was made as NIM based on earning assets is viewed by management as a more meaningful measure, as it only includes those assets that give rise to our reported net interest income including deposits with other banks, certain securities and loans. In conjunction with this change, we added residential mortgages securitized balances and reclassified certain income amounts in RBC Canadian Personal and Business. The securitization of residential mortgage and credit card loans and related results are offset in our Corporate Support segment. • We reclassified the mark-to-market changes in the fair value of derivative instruments designated as economic hedges for our stock-based compensation plan at RBC Dain Rauscher. This resulted in amounts being reclassified from Non-interest income to Non-interest expense – Stock-based compensation in order to more appropriately reflect the purpose of these instruments and our management of this compensation plan. The reclassification did not apply to other securities used to economically hedge RBC Dain Rauscher’s stock-based compensation plan. Consolidated results have been restated to reflect this change. • We transferred our housing tax credit syndication business • (1) (2) from RBC U.S. and International Personal and Business to RBC Capital Markets. Certain client-owned assets reported as assets under administra- tion (1) and as assets under management (2) were determined to be either incorrectly classified or qualified for classification under both terms. We reclassified certain portfolios to conform to our definitions. The segment and consolidated historic comparatives have been restated to reflect these changes. Assets under administration (AUA): Assets administered by us, which are beneficially owned by clients and are therefore not reported on the Consolidated Balance Sheets. 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 and are therefore not reported on the Consolidated Balance Sheets. Services provided in respect of assets under management include the selection of investments and the provision of investment advice. Assets under management may also be administered by us. Performance and non-GAAP measures We measure and evaluate the performance of our consolidated opera- tions 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). While net income is in accordance with GAAP, the others are considered non-GAAP financial measures. The measures reported that are not defined by GAAP do not have standard- ized meanings and may not be comparable to similar measures used by other companies. Return on equity and Return on risk capital We use ROE and RORC, at both the consolidated and segment levels, as a measure of return on total capital invested in our businesses. Our con- solidated 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 net income available to common shareholders divided by average attributed capital for the period. For each segment, average attributed capital is based on attrib- uted risk capital and amounts invested in goodwill and intangibles (1). In the second quarter of 2005, goodwill was reallocated, in accordance with GAAP. For segment reporting purposes the unattributed capital is reported in Corporate Support. GAAP does not prescribe a methodology for attributing capital or risk capital to business segments or for computing segment ROE or RORC, and there is no generally accepted methodology for doing so. Such attributions involve the use of assumptions, judgments and methodologies that are regularly reviewed and revised as deemed nec- essary. 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. (1) For internal allocation and measurement purposes, total attributed capital is deemed by management to be comprised of 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. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 47 RORC is used at both the consolidated and business segment levels 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 for supporting investment and resource allocation decisions because they adjust for certain items that may affect comparability between business segments and certain competitors. Table 17 provides a reconciliation of the RORC calculations. Return on equity and Return on risk capital reconciliation (C$ millions, except for percentage amounts) (1), (2) Net income from continuing operations Net loss from discontinued operations Net income less: Preferred dividends (3) RBC Canadian Personal and Business RBC U.S. and International Personal and Business 2006 RBC Capital Markets Table 17 2005 2004 Corporate Support Total Total Total $ 2,794 – $ 2,794 (22) $ $ 444 – $ 1,407 – 444 (8) $ 1,407 (12) $ $ 112 – $ 4,757 (29) $ 3,437 (50) $ 3,023 (220) 112 (18) $ 4,728 (60) $ 3,387 (38) $ 2,803 (31) Net income available to common shareholders $ 2,772 $ 436 $ 1,395 $ 94 $ 4,668 $ 3,349 $ 2,772 Average equity less: Unattributed capital less: Goodwill and intangible capital Average risk capital (4) Return on equity (ROE) Return on risk capital (RORC) $ 8,800 – 2,350 $ 6,450 $ 3,200 – 1,250 $ 1,950 $ 4,750 – 1,050 $ 3,700 $ 3,150 2,500 – 650 $ 31.5% 43.1% 13.6% 22.4% 29.3% 37.7% 3.0% n.m. Return on equity (ROE) from continuing operations Return on risk capital (RORC) from continuing operations $ 19,900 2,500 4,650 $ 12,750 23.5% 36.7% 23.3% 37.0% $ 18,600 2,300 4,850 $ 11,450 $ 17,800 1,100 5,400 $ 11,300 18.0% 29.3% 15.6% 24.6% 18.1% 29.7% 16.8% 26.5% (1) The average risk capital, goodwill and intangible capital, average attributed capital and average equity figures shown above and throughout this document represent rounded figures. These amounts are calculated using methods intended to approximate the average of the daily balances for the period. The ROE and RORC measures shown above and throughout this document are based on actual balances before rounding. Business segment ROE and RORC are calculated on a continuing operations basis only. Total (consolidated) return on common equity and RORC include continuing and discontinued operations. Preferred dividends include a net gain on redemption of preferred shares. Average risk capital includes credit, market (trading and non-trading), insurance, operational, business and fixed assets risk capital. For further details, refer to the Capital management section. (2) (3) (4) n.m. not meaningful RBC Capital Markets total revenue (teb) excluding revenue related to Consolidated Variable Interest Entities (VIEs) We consolidate certain entities in accordance with CICA AcG-15, Consolidation of Variable Interest Entities (VIEs). Consolidation of a VIE is based on our exposure to variability in the VIE’s assets and not on whether we have voting control. Revenue and expenses from certain of these VIEs have been included in RBC Capital Markets results. However, the amounts that have been consolidated, which are attributable to other equity investors in these VIEs are offset in Non-controlling interest in net income of subsidiaries and have no impact on our reported net income. As the amounts attributable to other equity investors do not have an impact on our reported net income, management believes that adjusting for these items enhances the comparability of RBC Capital Markets results and related ratios and enables a more meaningful com- parison of our financial performance with other financial institutions. As the expenses are not viewed as material, we have only adjusted for the revenue attributed to other equity investors. The following table provides a reconciliation of total revenue (teb) excluding VIEs for RBC Capital Markets. RBC Capital Markets total revenue (teb) excluding VIEs (C$ millions) Total revenue (teb) (1) Revenue related to VIEs offset in Non-controlling interest (2) Total revenue (teb) excluding VIEs Table 18 2006 4,693 (7) $ 2005 4,062 (24) $ 2004 3,933 – 4,700 $ 4,086 $ 3,933 $ $ (1) (2) Taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. Represents revenue attributed to other equity investors of consolidated VIEs which is offset in Non-controlling interest in net income of subsidiaries. Royal Bank of Canada Annual Report 2006 48 Management’s Discussion and Analysis Results excluding Enron provision In the fourth quarter of 2005, we recorded a litigation charge of $591 million ($326 million after-tax) for Enron-related matters, including a securities class action lawsuit brought on behalf of Enron securities holders in a federal court in Texas. Table 19 provides a reconciliation of our RBC Capital Markets and consolidated GAAP results for 2005 to exclude the Enron provision. Management believes that adjusting this amount provides a meaningful measure for comparison to other periods. 2005 Results excluding Enron provision (C$ millions, except per share amounts) Reported (2) RBC Capital Markets (1) RBC Consolidated Enron litigation provision Excluding Enron litigation provision Reported (2) Enron litigation provision Table 19 Excluding Enron litigation provision Continuing operations Non-interest expense Income taxes Net income from continuing operations Net income Earnings per share from continuing operations – diluted Earnings per share – diluted $ $ 3,274 137 $ $ 591 265 2,683 402 $ 11,357 1,278 760 $ 326 $ 1,086 $ $ $ $ 3,437 3,387 2.61 2.57 $ $ $ $ $ 591 265 326 326 .25 .25 $ 10,766 1,543 $ $ $ $ 3,763 3,713 2.86 2.82 (1) (2) Certain segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Income taxes for RBC Capital Markets are reported on a taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. 2006 Adjusted operating leverage Operating leverage is the difference between our revenue growth rate and the non-interest expense growth rate. Our 2006 operating leverage objective of greater than 3% excluded the 2005 Enron provision of $591 million from non-interest expense. While we performed well against our earnings measures, our operating leverage for 2006 of 1% did not meet our target. This was largely attributed to the impact of our business mix and certain factors, which contributed to earnings growth, but were not appropriately captured in this measure. These factors included the impact of tax-advantaged sources, consolidated VIEs and insurance-related revenue and expense. During the year, we experienced higher than expected earnings growth from our wealth management and capital markets businesses, which included higher earnings from certain tax-advantaged sources (Canadian taxable corporate dividends), which are not appropriately reflected in our revenue growth, while the related expense was fully captured in expense growth. We also realized lower than expected insurance-related revenue, which in turn largely resulted in lower policy- holder benefits, claims and acquisition expense. While the reduction in insurance-related revenue reduced the ratio, the related reduction in policyholder benefits claims and acquisition expense was not captured in our operating leverage calculation, as it was not reflected in expense 2006 Adjusted operating leverage (C$ millions, except percentage amounts) Total revenue add: teb adjustment less: Revenue related to VIEs less: Gross insurance revenue Total revenue (adjusted) Non-interest expense less: 2005 Enron provision Non-interest expense excluding the Enron provision less: Insurance non-interest expense Non-interest expense (adjusted) Operating leverage Adjusted operating leverage growth. In addition, consolidated VIEs impacted our revenue, and consequently our operating leverage. However, as their earnings are attributed to other equity investors and offset in Non-controlling interest in income of subsidiaries, they have no impact on our reported net income. We concluded that revenue growth should be based on a tax- able equivalent basis, while the impact of consolidated VIEs should be excluded as they have no material impact on our earnings. We also con- cluded insurance-related revenue and expenses should not be included in the determination of the operating leverage ratio, as their impact cannot be appropriately recognized in the ratio. We have adjusted our 2007 operating leverage calculation to incorporate these factors in order to more appropriately reflect the performance of our businesses going forward. If this new approach was applied to our 2006 results, our adjusted operating leverage would have been 2.5%, which although still below our target, is a more meaningful measure and indicator of our performance. The following table shows our 2006 operating leverage ratio based on our reported GAAP revenue and expense and the adjustments to our 2006 operating leverage to conform to our 2007 adjusted operating leverage ratio calculation. 2006 vs. 2005 Increase (decrease) 2006 $ 20,637 213 (7) 3,348 $ 17,509 $ 11,495 – $ 11,495 517 $ 10,978 $ $ $ $ $ 2005 19,184 109 (24) 3,311 16,006 11,357 591 10,766 501 10,265 $ $ $ $ $ 1,453 104 17 37 1,503 138 (591) 729 16 713 Operating leverage 7.6% 6.8% 0.8% Table 20 Adjusted operating leverage 9.4% 6.9% 2.5% Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 49 RBC Canadian Personal and Business • • • Net income increased $490 million, or 21%, reflecting a broad-based increase across business lines. Strong revenue growth in wealth management and banking businesses of $845 million, or 9%. Solid volume growth in most of our business lines reflecting our successful execution of growth initiatives and continuing favourable economic conditions. RBC Canadian Personal and Business segment consists of our personal and business banking and wealth management businesses in Canada as well as our global insurance business. This segment is comprised of Personal Banking, Business Financial Services, Cards and Payment Solutions, Wealth Management and Global Insurance. RBC Canadian Personal and Business provides a broad suite of financial products and services to over 13 million individual and busi- ness clients through our extensive branch, automated banking machine, online and telephone banking networks, as well as through a large number of proprietary sales professionals and investment advisors in addition to a wide-ranging third-party network of independent insur- ance distributors. We have 3.5 million online and 2.9 million telephone clients. We have top rankings in most retail businesses and the leading full-service brokerage operation. We are also the top mutual fund provider among Canadian banks as well as the largest Canadian bank- owned insurer. Business highlights • RBC Asset Management led the Canadian mutual fund industry in long-term net sales for the third consecutive year, with net sales of • • • $5.4 billion. It has over $68 billion in assets under management or an 11% market share, representing Canada’s largest single fund family. During 2006, total personal loans grew 13%, and RBC moved to the number one Canadian market share position at 15%. RBC Homeline Plan portfolio grew 117% over last year, with the total balance outstanding in excess of $27 billion as of October 2006. 2006 was a year of continued and accelerated focus on our network distribution capability. In Canada, we opened fourteen banking branches and seven insurance branches. Economic and market review In 2006, Canadian economic growth was strong, underpinned by a rela- tively favourable interest rate environment, strong employment levels and higher wages, and a solid yet moderating housing market, which contributed to increased demand for consumer and business loans, as well as other financial products. Competition in the personal deposits business continued to increase from both traditional and niche financial institutions which offer high-interest savings products. The generally favourable capital market conditions during the year continued to sup- port the growth of our wealth management business. RBC Canadian Personal and Business financial highlights (1) (C$ millions, except percentage amounts) Net interest income Non-interest income Total revenue Non-interest expense Provision for credit losses (PCL) Insurance policyholder benefits, claims and acquisition expense Business realignment charges Net income before income taxes and non-controlling interest in subsidiaries Net income Key ratios Return on equity (2) Return on risk capital (2) Net interest margin (3) Operating leverage (excluding Global Insurance) (4) Selected average balance sheet and other information (5) Total assets (6) Total earning assets (6) Loans and acceptances (6) Deposits Attributed capital (2) Risk capital (2) Assets under administration Assets under management Credit information Gross impaired loans as a % of average loans and acceptances Specific PCL as a % of average loans and acceptances Other information Number of employees (full-time equivalent) 2006 2005 2004 Table 21 $ 5,941 7,440 $ 13,381 6,140 604 2,509 – 4,128 2,794 $ $ $ 5,348 7,151 $ 12,499 5,872 542 2,625 7 3,453 2,304 $ $ $ 4,876 6,337 $ 11,213 5,630 410 2,124 63 2,986 2,043 $ $ 31.5% 43.1% 3.27% 4.5% 27.1% 39.1% 3.26% 5.5% 24.7% 37.6% 3.31% (.5)% $ 200,700 181,500 180,500 145,700 8,800 6,450 213,200 89,700 $ 182,400 163,900 161,500 138,800 8,450 5,850 180,300 72,100 $ 164,100 147,200 145,300 133,700 8,200 5,400 157,300 58,700 .33% .33% .31% .34% .44% .33% 28,271 27,045 27,366 (1) (2) (3) (4) (5) (6) Certain segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. Reported amounts include securitized residential mortgage and credit card loans. For further discussion, refer to the How we manage our business segments section. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. Segment Return on equity, Average risk capital and Return on risk capital are non-GAAP financial measures. For further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Net interest margin (NIM) is calculated as Net interest income divided by Average earning assets. Average earning assets are calculated using methods intended to approximate the average earnings asset balances for the period. Defined as the difference between revenue growth rate and non-interest expense growth rate for the segment, excluding Global Insurance due to the nature of its business. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Total assets, total earning assets, and loans and acceptances include average securitized residential mortgage and credit card loans for the year of $14.9 billion and $3.7 billion, respectively. Royal Bank of Canada Annual Report 2006 50 Management’s Discussion and Analysis Revenue by business line (C$ millions) 15,000 12,000 9,000 6,000 3,000 0 2004 2005 2006 Personal Banking Business Financial Services Cards and Payment Solutions Wealth Management Global Insurance Financial performance 2006 vs. 2005 Net income for the year of $2,794 million increased $490 million, or 21%, from a year ago. The increase largely reflected strong revenue growth in our wealth management and banking businesses, and lower hurricane-related charges this year. The increase was partly offset by higher variable compensation on stronger business performance, increased costs in support of business growth and higher provision for credit losses partly due to loan growth and lower recoveries. Total revenue increased $882 million, or 7%, over the prior year, largely reflecting strong volume growth and improved deposit and investment spreads in our banking and wealth management businesses, which combined for an increase in revenue of $845 million, or 9%. These results continued to reflect our successful execution of growth initiatives and the continuing favourable economic conditions. Net interest margin increased 1 bp over last year to 3.27%, primar- ily reflecting improved spreads on deposits and investment products. Non-interest expense was up $268 million, or 5%, mainly as a result of higher variable compensation on stronger business perfor- mance, higher levels of sales personnel and infrastructure costs in our distribution network, and higher advertising and marketing costs in sup- port of business growth. Provision for credit losses increased $62 million, or 11%, largely reflecting higher provisions in our personal loan and small business portfolios and lower recoveries in our agriculture portfolio this year. The prior year included our 50% proportionate share of a provision booked at Moneris. Insurance policyholder benefits, claims and acquisition expense decreased $116 million, or 4%, compared to the prior year. The decrease primarily reflected a $142 million (before- and after-tax) reduction in charges for estimated net claims for damages related to hurricanes, 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 this year. Average assets increased $18 billion, or 10%, over the prior year, largely due to strong loan growth, underpinned by our successful execu- tion of growth initiatives, solid business and household balance sheets, and strong labour market conditions. Deposits were up $7 billion, or 5%, from a year ago mainly due to growth in business deposits. 2005 vs. 2004 Net income increased $261 million, or 13%, from a year ago. The increase primarily reflected strong revenue growth across all business lines, which was partially offset by charges for hurricane-related estimated net claims, higher costs associated with increased sales and service personnel in our Canadian branch network, and higher provision for credit losses largely reflecting a $78 million reversal of the general allowance recorded in 2004. Total revenue increased $1,286 million, or 11%, over the prior year, largely due to strong growth in our disability insurance business, which included UnumProvident since May 1, 2004, and higher volumes in lending and deposits. The increase also resulted from robust mutual fund sales, and increased brokerage and investment management fees related to higher client assets, transaction volumes and higher service fees. Non-interest expense increased $242 million, or 4%, primarily due to increased sales and service personnel in our distribution network, higher variable compensation associated with strong business perfor- mance and higher benefit costs. Higher advertising and new program costs in support of our business growth also contributed to the increase. Provision for credit losses increased $132 million, largely reflecting a $78 million reversal of the general allowance in 2004, as well as higher provisions commensurate with loan growth. Insurance policyholder benefits, claims and acquisition expense increased $501 million, or 24%, over the prior year. The increase was largely due to higher business volumes in the disability insurance busi- ness, which included UnumProvident since May 1, 2004, and the impact of charges for estimated net claims related to hurricanes Katrina, Rita and Wilma. 2007 Outlook and priorities The Canadian economic and business environment is expected to remain favourable for business growth. We expect continued strong performance from our wealth management, banking and insurance businesses, supported by generally favourable economic, labour and capital market conditions, and our successful implementation of growth initiatives. We will remain focused on new client acquisition and growth in high-value markets, augmenting our strengths in client insights and analytics, distribution capabilities and risk management, as well as product breadth and integration, with increased emphasis on our local competitiveness, and providing superior client service. Key strategic priorities for 2007 • • • Enhance client service, improve problem resolution and offer high-quality products and services to achieve industry leading client loyalty, increase client retention and generate superior results. Expand and enhance our extensive distribution networks through increased contact points and improved integration to truly differentiate ourselves from the competition and extend our leadership position. Continue to streamline our processes and structures to make it easier for our clients to do business with us and to improve the ability of our employees to deliver cost-effective and efficient solutions. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 51 Business line review Personal Banking Personal Banking focuses on meeting the needs of our individual clients at every stage of their lives through a wide range of products and services, including home equity financing, lines of credit, core deposits, personal loans and automotive financing. We have the largest retail banking network in Canada with over 1,100 branches and 3,800 automated banking machines. We also rank first or second in market share for most personal banking products, including 16% market share of residential mortgages and 14% of personal loans. Financial performance Revenue increased $226 million, or 7%, over the prior year, primarily reflecting strong loan growth particularly in home equity lending and improved spreads on deposits. Average personal loans increased 12% and average residential mortgage balances were up 12% over the prior year, underpinned by relatively low interest rates, a continued solid housing market and a firm labour market. Average personal deposit balances increased 2% from a year ago notwithstanding an increasingly competitive market. Business Financial Services Business Financial Services offers a wide range of lending, leasing, deposit and transaction products and services to small and medium- sized businesses, and 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 96 business banking centres, and our strong commitment to our clients has resulted in top market share in business loans and deposits. Financial performance Revenue increased $130 million, or 6%, over the prior year largely as a result of strong growth in business loans and deposits. Average busi- ness loans grew by 10% on favourable economic conditions, while average business deposits increased 15% driven by high liquidity within Canadian businesses. Royal Bank of Canada Annual Report 2006 52 Management’s Discussion and Analysis Selected highlights (1) Table 22 (C$ millions) $ Total revenue Other information (average) (2) Residential mortgages Personal loans Personal deposits New accounts opened (thousands) 2006 2005 2004 3,614 $ 3,388 $ 3,094 100,800 34,400 32,600 769 89,700 30,600 31,900 740 79,900 27,000 30,800 715 (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. Reported amounts include securitized residential mortgages. For further discussion, refer to the How we manage our business segments section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Average residential mortgages, personal loans and deposits (C$ millions) 120,000 96,000 72,000 48,000 24,000 0 2004 2005 2006 2004 2005 2006 35,000 Residential mortgages 28,000 Personal loans Personal deposits 21,000 14,000 7,000 0 Selected highlights (1), (2) Table 23 (C$ millions) 2006 2005 2004 Total revenue Other information (average) (2) Business loans Business deposits $ 2,141 $ 2,011 $ 1,888 35,800 48,600 32,400 42,400 30,100 39,200 (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Average business loans and deposits (C$ millions) 40,000 32,000 24,000 16,000 8,000 0 2004 2005 2006 2004 2005 2006 50,000 Business loans 40,000 Business deposits 30,000 20,000 10,000 0 Cards and Payment Solutions Cards and Payment Solutions provides a wide array of convenient and customized credit cards and related payment products and solutions. We have over 5 million credit card accounts and have approxi- mately 20% market share of Canada’s credit card purchase volume. Financial performance Revenue increased $91 million, or 6%, over the prior year, largely reflecting strong growth in new clients supported by ongoing marketing initiatives, higher client spending and balances and the receipt of a fee related to the termination of an agreement. These factors were partially offset by higher costs related to our customer loyalty reward program. Average card balances increased 13% and net purchase volume grew by 15%, reflecting strong labour market conditions and continued consumer confidence. Selected highlights (1) Table 24 (C$ millions) 2006 2005 2004 Total revenue Other information Average card balances (2) Net purchase volumes $ 1,586 $ 1,495 $ 1,341 9,900 41,500 8,800 36,100 7,900 30,600 (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. Reported amounts include securitized credit card loans. For further discussion, refer to the How we manage our business segments section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Average credit card balances and net purchase volumes (C$ millions) Wealth Management Wealth Management provides investment and trust products and ser- vices through our branch network of licensed mutual fund salespeople, as well as through full-service and self-directed brokerage, asset management, trust services, investment counselling and private bank- ing. Wealth Management includes RBC Dominion Securities, RBC Direct Investing and RBC Asset Management. RBC Dominion Securities continues to be the market leader in full- service brokerage in Canada, with over 1,300 investment advisors and $145 billion of assets under administration. RBC Direct Investing is the second largest Canadian self-directed brokerage as measured by assets under administration. In 2006, RBC Direct Investing introduced market- leading pricing for active investors, and has significantly enhanced its online capabilities. RBC Asset Management provides a broad range of investment ser- vices and products including mutual funds, pooled funds and separately managed portfolios marketed and distributed by our branch network of 9,700 licensed mutual fund salespeople, full-service and self-directed brokerage, as well as independent financial planners. Financial performance Revenue was up $398 million, or 17%, over the prior year. The increase reflected higher spreads on personal investment products and client balances, strong net sales and capital appreciation in mutual funds and continued growth in fee-based accounts. The strong investment perfor- mance of the RBC family of funds also contributed to a 25% increase in assets under management. The GIC portfolio remained relatively stable over the past three years, despite a higher portion of investment purchases being directed towards long-term mutual funds. 10,000 8,000 6,000 4,000 2,000 0 2004 2005 2006 2004 2005 2006 Average card balances Net purchase volumes 50,000 40,000 30,000 20,000 10,000 0 Selected highlights (1) Table 25 (C$ millions) 2006 2005 2004 Total revenue Other information Long-term mutual fund net sales Assets under administration Assets under management GICs (2) $ 2,692 $ 2,294 $ 2,015 5,450 191,800 89,500 57,000 5,982 166,200 71,800 57,200 3,883 147,600 58,200 56,700 (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Assets under administration and management (C$ millions) 200,000 160,000 120,000 80,000 40,000 0 2004 2005 2006 2004 2005 2006 Assets under administration Assets under management 100,000 80,000 60,000 40,000 20,000 0 Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 53 Insurance claims and policy benefit liabilities increased $220 million, or 3%, over the prior year, primarily reflecting business growth in our Canadian life business and European life reinsurance business. The increase was partially offset by our lower property catastrophe reinsur- ance liabilities, net payment of claims related to hurricanes, and a net decrease of $15 million of life and health insurance liabilities reflecting changes to various actuarial assumptions. Selected highlights (1) (C$ millions) Total revenue Non-interest expense Insurance policyholder benefits, claims and acquisition expense Net income before income taxes Insurance claims and policy benefit liabilities Other selected information (in thousands) Canadian life and health policies in force and certificates (2) U.S. life policies in force Home and auto – personal lines policies in force Travel coverages 2006 2005 $ 3,348 $ 517 3,311 $ 501 2,509 322 2,625 186 Table 26 2004 2,875 501 2,124 242 7,337 7,117 6,488 2,295 1,374 254 2,843 2,245 1,860 233 2,323 2,203 1,976 193 2,121 (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Excludes accidental death and dismemberment which is no longer marketed. Global Insurance revenue and insurance policyholder benefits, claims and acquisition expense (C$ millions) 3,500 2,800 2,100 1,400 700 0 2004 2005 2006 2004 2005 2006 Global Insurance revenue Insurance policyholder benefits, claims and acquisition expense 3,000 2,400 1,800 1,200 600 0 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, a proprietary sales force, Internet and retail insurance offices. Our insurance products are distributed through more than 17,000 independent brokers in Canada and more than 650 career sales repre- sentatives in North America. Our Canadian insurance business holds lead positions in creditor, travel and individual health insurance prod- ucts, and has a significant presence in life, home and auto insurance. During 2006, we strategically reduced our exposure in property catastrophe reinsurance, as we have ceased underwriting new business and focused on managing the remaining claim liabilities related to previous commitments. Financial performance Net income before income taxes increased $136 million, or 73%, primarily reflecting the reduction in charges of $142 million (before- and after-tax) for the estimated net claims for damages related to hurricanes, as we recorded $203 million in 2005 related to hurricanes Katrina, Rita and Wilma and $61 million for additional net claims in 2006 predominantly related to Hurricane Wilma. In addition, business growth associated with Canadian life business and European life reinsurance business, as well as improved claims experience in our Canadian prop- erty and casualty business also contributed to the increase. These factors were partially offset by lower revenue from property catastrophe reinsurance reflecting our strategic reduction in exposure. Total revenue increased $37 million, or 1%, over the prior year, primarily reflecting growth in our Canadian life business and European life reinsurance business. These factors were mainly offset by lower revenue in our U.S. life business largely due to lower annuity sales, the negative impact on the translated value of U.S. dollar-denominated revenue resulting from the stronger Canadian dollar, and policy lapses on discontinued and mature product lines. Lower revenue from property catastrophe reinsurance reflecting our strategic reduction in exposure and the gain on sale of Liberty Insurance Services in 2005 also offset the increase in revenue. Non-interest expense was up $16 million, or 3%, compared to the previous year. This primarily reflected growth in our Canadian life business and increased marketing and system development costs, which were partially offset by the lower translated value of U.S. dollar- denominated expense. Insurance policyholder benefits, claims and acquisition expense decreased $116 million, or 4%, compared to the prior year. The decrease primarily reflected a $142 million (before- and after-tax) reduction in hurricane-related charges for estimated net claims, 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. These factors were partially offset by higher benefit and claim costs associated with business growth and a reduced level of net favourable actuarial liability adjustments this year. Royal Bank of Canada Annual Report 2006 54 Management’s Discussion and Analysis RBC U.S. and International Personal and Business • Net income of $444 million increased 15% over the prior year. In U.S. dollars, net income was up 23%, driven by a strong improvement across all businesses. • Wealth Management revenue rose 9%, or 17% in U.S. dollars, and assets under administration increased 38%, in U.S. dollars, resulting from our successful execution of growth initiatives, including the acquisition of Abacus. Banking revenue was down 1%, but increased 7% in U.S. dollars, with loans and deposits up 10% and 5%, respectively, in U.S. dollars. • RBC U.S. and International Personal and Business consists of our personal and business banking and retail brokerage businesses in the U.S., banking in the Caribbean, and private banking internationally. This segment is comprised of Wealth Management, which includes Global Private Banking and certain activities of RBC Dain Rauscher, and Banking, which includes our RBC Centura and Caribbean banking operations. 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. Business highlights • RBC Dain Rauscher grew its assets under administration to a record level of US$132 billion, an increase of 14% over 2005, driven by solid equity market performance, recruiting experienced financial consultants and executing on its primary advisor strategy. RBC Centura increased its new personal account openings by 37% and new business account openings by 20% following the launch in the first quarter of 2006 of a new suite of personal and business chequing accounts with unique features to better meet client needs. • • • • Caribbean banking grew its loans and deposits by 17% and 8%, respectively, in U.S. dollars, by focusing on enhanced sales management and client satisfaction. Global Private Banking completed the acquisition of Abacus on November 30, 2005, expanding its presence in the U.K. and Channel Islands and increasing assets under administration by US$41 billion. Global Private Banking added a U.S. trust capability, with its acqui- sition of American Guaranty & Trust, which administers more than 1,000 personal trusts and holds more than US$1.3 billion in trust and investment accounts for its clients. Economic and market review The U.S. economy experienced solid growth throughout most of 2006, which continued to support business growth and the credit quality of our loan portfolio. However, rising interest rates and slowing housing markets in the U.S. did start to moderate the demand for loans. The U.S. and most international equity market indices increased over the year, which positively impacted revenue in our brokerage operations. Internationally, solid economic growth in many regions, including the Caribbean, supported business and revenue growth. RBC U.S. and International Personal and Business financial highlights (1) (C$ millions, except number of and percentage amounts) Net interest income Non-interest income Total revenue Non-interest expense Provision for credit losses (PCL) Business realignment charges Net income before income taxes and non-controlling interest in subsidiaries Net income Key ratios Return on equity (ROE) (2) Return on risk capital (RORC) (2) Selected average balance sheet and other information (3) Total assets Loans and acceptances Deposits Attributed capital (2) Risk capital (2) Assets under administration Assets under management Credit information Gross impaired loans as a % of average loans and acceptances Other information Number of employees (full-time equivalent) (US$ millions) Net interest income Non-interest income Total revenue Non-interest expense Provision for credit losses (PCL) Business realignment charges Net income before income taxes and non-controlling interest in subsidiaries Net income 2006 1,109 1,763 2,872 2,260 26 1 585 444 $ $ $ $ 2005 1,108 1,620 2,728 2,150 51 (2) 529 387 $ $ $ $ $ $ $ $ 13.6% 22.4% 11.8% 19.6% Table 27 2004 989 1,713 2,702 2,330 80 23 269 214 5.4% 9.1% $ 39,000 20,700 33,600 3,200 1,950 307,900 53,400 $ 37,700 20,500 33,300 3,250 1,950 234,300 46,700 $ 37,100 18,800 33,100 3,800 2,250 233,700 44,200 .90% .79% 1.17% 11,238 10,512 10,644 2006 980 1,557 2,537 1,997 22 1 517 393 $ $ $ $ 2005 912 1,336 2,248 1,771 41 (2) 438 320 $ $ $ $ 2004 753 1,304 2,057 1,774 61 19 203 162 $ $ $ $ (1) (2) (3) Certain segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. Segment Return on equity, Average risk capital and the Return on risk capital are non-GAAP financial measures. For a further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 55 Revenue by business line (C$ millions) Revenue by business line (US$ millions) 3,000 2,400 1,800 1,200 600 0 Banking Wealth Management 3,000 2,400 1,800 1,200 600 0 2004 2005 2006 2004 2005 2006 Banking Wealth Management Impact of U.S. vs. Canadian dollar The translated value of this segment’s U.S. dollar-denominated results is impacted by fluctuations in the U.S./Canadian dollar exchange rate. The table below depicts the impact of translating the specified year’s U.S. dollar-denominated results at the average exchange rate in effect during that period in comparison to the prior year’s average 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 change in the exchange rate over the comparable periods and the resulting impact on our results. The Canadian dollar appreciated 7% on average relative to the U.S. dollar compared to a year ago. As well, in 2005, the Canadian dollar appreciated 8% on average relative to the U.S. dollar, compared to 2004. Impact of USD translation on selected items (1) Table 28 (C$ millions, except for percentage amounts) Reduced total revenue Reduced non-interest expense Reduced net income Percentage change in the average US$ equivalent of C$1.00 (2) $ 2006 vs. 2005 2005 vs. 2004 161 $ 123 28 7% 187 141 33 8% (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Average amounts are calculated using month-end spot rates for the period. Financial performance 2006 vs. 2005 Net income increased $57 million, or 15%, from the prior year, despite a $28 million reduction due to the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated earnings. In U.S. dollars, net income was up US$73 million, or 23%, driven by strong revenue growth in Wealth Management and solid business growth and improved credit quality in Banking. Revenue increased $144 million, or 5%, over the prior year. In U.S. dollars, revenue was up US$289 million, or 13%. Wealth Management revenue improved $151 million, or 9%. In U.S. dollars, Wealth Management revenue was up US$231 million, or 17%, mainly due to the inclusion of Abacus, higher securities brokerage commissions in Global Private Banking and growth in fee-based client assets at RBC Dain Rauscher. Banking revenue decreased $7 million, or 1%, compared to the prior year. In U.S. dollars, Banking revenue increased US$58 million, or 7%, reflecting solid loan and deposit growth and higher fee-based activities. Non-interest expense was up $110 million, or 5%, over the prior year. In U.S. dollars, non-interest expense increased US$226 million, or 13%, largely reflecting the inclusion of Abacus and increased variable compensation, primarily in Wealth Management on stronger revenue. The increase also reflected higher project-related spending and other costs in support of business growth. Provision for credit losses was down $25 million, or 49%. In U.S. dollars, the decrease was US$19 million, reflecting continued strong credit quality in our loan portfolio at RBC Centura. Royal Bank of Canada Annual Report 2006 56 Management’s Discussion and Analysis 2005 vs. 2004 Net income increased $173 million, or 81%, from 2004, despite a $33 million reduction due to the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar-denominated earnings. In U.S. dollars, net income improved US$158 million, or 98%, reflecting strong improvement in all businesses. 2004 also included $23 million ($14 million after-tax) of business realignment charges. Revenue increased $26 million, or 1%. In U.S. dollars, revenue increased US$191 million, or 9%, over the prior year. This increase largely reflected solid loan and deposit growth in our Banking opera- tions, higher fee-based client assets at RBC Dain Rauscher and higher net interest income and fee-based activity at Global Private Banking. These factors were partly offset by a gain from the sale of our merchant acquiring card portfolio to Moneris recorded in the prior year. Non-interest expense declined $180 million, or 8%. In U.S. dollars, non-interest expense was down US$3 million, reflecting the valuation allowance recorded in 2004 relating to certain mortgage loans believed to have been fraudulently originated in 2001 and 2002. Cost- containment efforts also contributed to the decrease. These factors were largely offset by higher variable compensation on better performance of our businesses. Provision for credit losses decreased $29 million, or 36%. In U.S. dollars, provision for credit losses was down US$20 million, reflecting improved credit quality of our loan portfolio. 2007 Outlook and priorities We continue to see significant opportunity in the U.S. and globally to expand our Banking and Wealth Management businesses, both through organic growth and strategic acquisitions. We expect the U.S. economy to moderate in 2007 given the slowdown in the housing market and the softening of consumer spending and corporate profitability due to the lagged effect of previous interest rate increases. Competitive pricing is expected to continue to put pressure on our margins. In 2007, we expect the U.S. dollar to appreciate moderately relative to the Canadian dollar in response to weaker energy prices, negative interest rate spreads versus the U.S. market and the stabilization of the U.S. fiscal and trade deficits. Key strategic priorities for 2007 • Continue to grow RBC Dain Rauscher through its primary advisor strategy and by partnering with RBC Centura, Global Private Banking and RBC Capital Markets to build on our credit and lending capabilities, trust services, and delivery of structured products and alternative investments. Expand Global Private Banking’s market share among high net worth individuals by strengthening and building relationships with centres of influence, adding distribution and expanding product offerings. Continue to grow RBC Centura by focusing on meeting the needs of businesses, business owners and professionals, and expanding our network in key high-growth markets. Build on our current strong position in the Caribbean through organic growth and operational improvements. • • • Business line review Wealth Management Wealth Management is comprised of RBC Dain Rauscher and our Global Private Banking operations. RBC Dain Rauscher offers investment, advisory and asset management services to individuals, and clearing and execution services to small and mid-sized independent broker-dealers and institutions in the U.S. RBC Dain Rauscher ranks as the 8th largest full-service securities firm in the U.S. with its network of 1,680 financial consultants across the country. Global Private Banking provides high net worth individuals, corporate and institutional clients internationally with private banking and credit, trust services, discretionary investment management, full-service brokerage and global custody and fund administration. Global Private Banking has an international network of 33 offices in 21 countries and is recognized as one of the top 20 private banks in the world (Euromoney magazine). Financial performance Revenue in 2006 was $1,802 million, up $151 million, or 9%, compared to the prior year. In U.S. dollars, revenue increased US$231 million, or 17%, with assets under administration and assets under management up 38% and 20%, respectively. These results reflected the successful execution of our growth initiatives and solid U.S. and international equity market performance during the year. Global Private Banking generated strong revenue growth, largely driven by the inclusion of Abacus and higher securities brokerage commissions from new sales and business expansion. RBC Dain Rauscher had solid growth on higher fee-based client assets, reflecting recruiting of experienced financial consultants and progress on its primary advisor strategy. Banking Banking consists of our RBC Centura and Caribbean banking operations. These businesses offer a broad range of banking products and services to personal and business clients in their respective markets. RBC Centura ranks 6th in deposit market share in North Carolina and among the top 15 in its Southeast U.S. banking footprint. It has a network of 282 branches and 314 ABMs. Caribbean banking ranks in the top three in deposit market share in most of its markets and has 43 branches and 71 ABMs. Financial performance Banking revenue in 2006 was $1,070 million, a decrease of $7 million, or 1%, compared to the prior year, reflecting the negative impact of a stronger Canadian dollar on the translated value of U.S. dollar- denominated revenue. In U.S. dollars, revenue improved US$58 million, or 7%, driven by solid loan and deposit growth of 10% and 5%, respectively, and higher fee-based activities, both at RBC Centura and Caribbean banking. Business growth benefited from favourable eco- nomic conditions. However, rising interest rates and slowing housing markets in the U.S. did start to moderate demand for loans at RBC Centura. Banking’s net interest margin at 3.73% in 2006 declined 5 bps from the prior year, reflecting changes to asset mix, the flatter U.S. yield curve and competitive pricing. Selected highlights (1) Table 29 Total revenue (C$ millions) Other information (US$ millions) Total revenue Assets under administration Assets under management 2006 2005 2004 $ 1,802 $ 1,651 $ 1,658 1,592 274,200 47,500 1,361 198,400 39,500 1,263 191,800 36,300 (1) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Assets under administration and management (US$ millions) 275,000 220,000 165,000 110,000 55,000 0 2004 2005 2006 2004 2005 2006 Assets under administration Assets under management 50,000 40,000 30,000 20,000 10,000 0 Selected highlights (1) Table 30 Total revenue (C$ millions) Other information (US$ millions) Total revenue Net interest margin (2) Average loans and acceptances (3), (4) Average deposits (3), (4) Number of: Branches Automated banking machines 2006 2005 2004 $ 1,070 $ 1,077 $ 1,044 945 3.73% 887 3.78% 794 3.59% $ 15,100 $ 13,700 $ 11,900 13,900 15,100 15,900 325 385 315 371 317 372 (1) (2) (3) (4) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Net interest margin (NIM) is calculated as Net interest income divided by Average earning assets. Average earning assets are calculated using methods intended to approximate the average of the daily balances for the period. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Average loans and acceptances and Average deposits have been adjusted for 2004 and 2005 for netting of a large Caribbean government account effective fourth quarter 2005, which reduced loan and deposit balances by a similar amount. Average loans and acceptances and average deposits (US$ millions) 20,000 16,000 12,000 8,000 4,000 0 2004 2005 2006 2004 2005 2006 20,000 Loans and acceptances 16,000 Deposits 12,000 8,000 4,000 0 Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 57 RBC Capital Markets Record net income of $1,407 million. • • Revenue (teb) up $631 million, or 16%, largely reflecting record trading results and very strong M&A activity. • Continued to expand our municipal finance activities in the U.S. mid-market and our global infrastructure finance platform. RBC Capital Markets 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, and our 50% ownership in RBC Dexia IS. All other businesses are grouped under Other. We have an established reputation as a premier Canadian invest- ment 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 have an unwavering commitment to our businesses and rigorously 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. Business highlights • Record trading performance as we continue to expand our product offering and trading strategies. Advised on many of the largest announced M&A deals in Canada, including the acquisitions of Inco Limited and Dofasco Inc. • • • • Top-ranked debt new issue dealer for Canadian government and corporate bonds as well as Maple bonds; and top-ranked Senior Manager for U.S. Municipal bonds by the number of issues for the first three calendar quarters of 2006 (Thompson Financial). Leveraged our U.K. infrastructure and project finance capabilities into other international and U.S. client relationships, such as advising one of the first Florida public/private partnerships, the Tampa Hillsborough County Expressway Authority and an advisory role on a €1.2 billion new rail bypass project in France. Continued to build on our strengths in Alternative Assets, launching the RBC Hedge 250 Index, which was designed to be an investable benchmark index of hedge fund performance. Economic and market review During the year, capital markets conditions were generally favourable, characterized by strong trading conditions, including higher equity mar- ket volatility and a low but rising interest rate environment, near record high M&A activity and solid cash equities business which benefited from healthy foreign demand for Canadian natural resource-based equities. Equity origination activity started the year slowly and remained below expectations mainly reflecting uncertainty in equity markets outside the resource sector. Debt origination activity was also lower in the U.S. and Europe, largely due to the rising interest rate environment. The stronger Canadian dollar negatively impacted the translated value of our U.S. dollar- and GBP-denominated earnings. RBC Capital Markets financial highlights (1) (C$ millions, except percentage amounts) Net interest income (teb) (2) Non-interest income Total revenue (teb) (2) Non-interest expense Provision for (recovery of) credit losses (PCL) Business realignment charges Net income before income taxes (teb) and non-controlling interest in subsidiaries (2) Net income Key ratios Return on equity (ROE) (3) Return on risk capital (RORC) (3) Selected average balance sheet and other information (4) Total assets Trading securities Loans and acceptances Deposits Attributed capital (2) Risk capital (2) Assets under administration – RBC Assets under administration – RBC Dexia (5) Credit information Gross impaired loans as a % of average loans and acceptances Specific PCL as a % of average loans and acceptances Other selected balances Number of employees (full-time equivalent) 2006 201 4,492 4,693 3,058 (115) (1) 1,751 1,407 $ $ $ $ $ $ $ $ Table 31 2005 607 3,455 4,062 3,274 (91) 1 878 760 $ $ $ $ 2004 847 3,086 3,933 2,845 (108) 27 1,169 827 29.3% 37.7% 18.1% 23.8% 19.5% 26.3% $ 267,800 132,300 23,500 118,800 4,750 3,700 4,700 1,893,000 $ 229,300 109,600 17,600 98,900 4,100 3,150 1,363,600 – $ 219,300 91,100 18,600 88,400 4,200 3,150 1,202,900 – .26% (.28)% .67% (.52)% 2.18% (.05)% 2,938 4,670 4,640 (1) (2) (3) (4) (5) Certain segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. Average attributed capital and Return on equity are calculated using methods intended to approximate the average of the daily balances for the period. Segment return on equity, Average risk capital and the Return on risk capital are non-GAAP financial measures. For a further discussion and reconciliation, refer to the Key financial measures (non-GAAP) section. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Assets under administration – RBC Dexia IS represents the total AUA of RBC Dexia IS, of which we have a 50% ownership interest. As RBC Dexia IS reports on a one-month lag, AUA – RBC Dexia IS is as at September 30, 2006. Royal Bank of Canada Annual Report 2006 58 Management’s Discussion and Analysis Revenue (teb) by geography (C$ millions) Revenue (teb) by business line (C$ millions) 5,000 4,000 3,000 2,000 1,000 0 Other Europe U.S. Canada 5,000 4,000 3,000 2,000 1,000 0 2004 2005 2006 2004 2005 2006 Other RBC Dexia IS/IIS (1) GIBEM Global Markets Impact of US$ and British pound (GBP) vs. Canadian dollar The translated value of this segment’s U.S. dollar- and GBP-denominated results are impacted by fluctuations in the respective exchange rates to the Canadian dollar. The table below depicts the effect of translating the specified year’s U.S. dollar- and GBP-denominated results at the average exchange rates in effect during that period in comparison to the prior year’s average exchange rates. We believe this provides the reader with the ability to assess underlying results on a more comparable basis, particularly given the magnitude of the change in the exchange rates over the comparable periods and the resulting impact on our results. The Canadian dollar appreciated 7% on average and 9% on average relative to the U.S. dollar and GBP, respectively, compared to a year ago. Also, the Canadian dollar appreciated 8% on average relative to the U.S. dollar and 6% on average relative to the GBP in 2005 compared to 2004. Impact of US$ and GBP translation on selected items (1) Table 32 (C$ millions, except for percentage amounts) Reduced total revenue (teb) (2) Reduced non-interest expense Reduced net income Percentage change in average US$ equivalent of C$1.00 (3) Percentage change in average GBP equivalent of C$1.00 (3) 2006 vs. 2005 2005 vs. 2004 $ 218 $ 120 67 7% 9% 172 118 31 8% 6% (1) (2) (3) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Taxable equivalent basis. For further discussion, refer to the How we manage our busi- ness segments section. Average amounts are calculated using month-end spot rates for the period. Financial performance 2006 vs. 2005 Net income increased $647 million, or 85%, compared to a year ago. Excluding the prior year Enron litigation-related provision of $591 million ($326 million after-tax), net income increased $321 million, or 30%, compared to a year ago largely reflecting 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, lower debt and equity origination activity and the negative impact of a stronger Canadian dollar on the translated value of our U.S. dollar- and GBP-denominated earnings. Results excluding the Enron provision are a non-GAAP measure. For a reconciliation and further discussion, refer to the Key financial measures (non-GAAP) section. Total revenue (teb) increased $631 million, or 16%. The increase was primarily due to record trading results on improved market condi- tions 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 (1) 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. Also included is our proportionate share of RBC Dexia IS revenue for the nine months ended September 30, 2006, due to the one-month reporting lag. Revenue pre- sented for 2005 and 2004 represents revenue from our IIS business only. the rising interest rate environment and further weakening of the U.S. dollar. Net interest income (teb) declined $406 million, or 67%, primarily due to higher funding costs in support of growth in certain equity trading strategies. Non-interest income increased $1,037 million, or 30%, mainly due to higher equity trading revenue, higher M&A fees mainly in Canada, increased distributions from private equity invest- ments and higher credit fees. These factors were partially offset by lower debt and equity origination activity. Total revenue (teb) excluding VIEs was $4,700 million, up $614 million, or 15%, from a year ago. For further discussion and reconciliation of total revenue (teb) excluding VIEs, refer to the Key financial measures (non-GAAP) section. Non-interest expense decreased $216 million, or 7%. Excluding the prior year Enron provision, non-interest expense increased $375 million, or 14%, compared to the prior year primarily reflecting higher variable compensation on stronger business performance. Higher professional fees primarily related to business integration, and certain accounting adjustments to expenses, which increased both reported revenue and expenses, related to our 50 per cent ownership of RBC Dexia IS and higher spending in support of business growth initiatives also contrib- uted to the increase. These factors were partially offset by the $120 million reduction in the translated value of U.S. dollar- and GBP- denominated expenses due to the stronger Canadian dollar and the prior year settlement of the Enron MegaClaims bankruptcy lawsuit. Recovery of credit losses of $115 million was comprised of $65 million of recoveries of previously impaired corporate loans and the $50 million reversal of the general allowance. This compared to the $91 million recovery of credit losses realized in the prior year related to previously impaired corporate accounts. Income taxes increased $227 million from a year ago. Excluding the negative impact of the prior year Enron provision, income taxes decreased $38 million mainly due to higher earnings from international subsidiaries operating in lower income tax jurisdictions. Average assets continued to grow, up $39 billion, or 17%, primarily due to increased trading securities primarily resulting from growth in certain trading strategies. Loans and acceptances increased $6 billion, or 34%, primarily related to stronger investment banking activity and lending activity of RBC Dexia IS. Deposits increased $20 billion, or 20%, primarily due to increased funding requirements of our trading businesses. Credit quality remained strong, as gross impaired loans decreased $57 million, or 48%, from last year. 2005 vs. 2004 Net income decreased $67 million, or 8%, over the same period a year ago, primarily due to the Enron provision. This decrease was partly offset by moderate revenue growth, a lower effective tax rate, lower compensation costs and the Rabobank settlement charges incurred in 2004. Total revenue (teb) increased $129 million, or 3%. The increase was primarily due to higher origination activity in Canada and gains from the sale of an Enron-related claim. Partially offsetting the increase was lower Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 59 in new sectors and growth in U.S. dollar distribution. Also, core lending results are expected to increase as spread compression abates, while term extends. We also expect further growth in our infrastructure and project finance business as we continue to expand our capabilities from the U.K. to other international and U.S. markets, and growth from the expansion of structured and fixed income products into Asian markets. The Canadian dollar is expected to depreciate moderately relative to the U.S. and other foreign currencies as commodity and energy prices begin to ease. Our deal pipeline should remain healthy and is expected to continue to grow. Credit market conditions are expected to remain relatively favourable though the level of loan loss recovery opportunities is expected to continue to decline, commensurate with a lower level of problem loans. • Key strategic priorities for 2007 • Maintain our leadership position in Canada and deepen our penetration in the Canadian mid-market client segment. Continue to grow our Municipal Products business, expand our banking activities geographically and develop new product segments in the U.S. Successfully integrate new acquisitions and new businesses. Continue to expand the distribution of structured and fixed income products into Asian markets. Continue to expand our infrastructure and project finance product offering from U.K. to other international and U.S. markets. Continue to build our global energy capabilities. • • • • Selected highlights (1) Table 33 (C$ millions) Total revenue (teb) (2) Other information Trading-related Other 2006 2005 2004 $ 2,579 $ 2,256 $ 2,268 2,154 425 1,706 550 1,853 415 (1) (2) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. Trading-related and Other revenue (C$ millions) Other Trading-related 3,000 2,400 1,800 1,200 600 0 2004 2005 2006 trading revenue across all product categories due to challenging market conditions in 2005. Net interest income (teb) declined compared to 2004 primarily due to higher funding costs related to certain equity trading strategies and spread compression and reduced volumes in our lending portfolios. Non-interest income increased compared to 2004 primarily due to increased origination activity and gains on the sale of an Enron- related claim. Total revenue (teb) excluding VIEs was $4,086 million, up $153 million, or 4%, compared to 2004. Non-interest expense increased $429 million, or 15%, largely reflecting the Enron provision and the Enron MegaClaims bankruptcy settlement costs, partly offset by lower compensation costs, and the Rabobank settlement charges and business realignment charges incurred in 2004. Recovery of credit losses of $91 million in 2005, related to previously impaired corporate accounts, compared to recoveries of $108 million in 2004, which were largely comprised of a $99 million reversal of the general allowance. 2007 Outlook and priorities The outlook for capital markets globally is expected to remain relatively favourable with stable interest rates and improving equity markets. We expect to continue to expand our trading strategies and expect a modest rebound in origination activity, which will be partially offset by a weakening in M&A activity from a near historical high in 2006. Equity origination activity is expected to increase from a relatively slow 2006 as markets outside the resource and income trust sectors improve, while debt origination is expected to benefit from Municipal banking activity 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 Revenue (teb) increased $323 million, or 14%, from a year ago. The increase was primarily due to stronger trading results across all product categories. Higher private equity investment gains were mostly offset by lower debt origination fees, mainly in the U.S. Trading-related revenue was up 26% on improved market condi- tions and growth in several trading strategies. Other revenue was down 23% mainly due to lower debt origination fees, lower results from our housing tax credit syndication business and further weakening of the U.S. dollar during the year. During 2006, we led or jointly led 615 debt issues, up from 543 deals a year ago, with a total value of approximately $130 billion, and in Municipal Finance, we were involved in 642 issues with a total value of US$45 billion through the first three calendar quarters of 2006. Royal Bank of Canada Annual Report 2006 60 Management’s Discussion and Analysis 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. Financial performance Global Investment Banking and Equity Markets revenue increased $271 million, or 28%, compared to the prior year. This increase largely reflected higher M&A activity, increased credit fees related to our invest- ment banking activity, higher private equity distributions and the net gain realized on the exchange of our NYSE seats for NYX shares. These factors were partially offset by lower equity origination activity due to market uncertainty outside the resource and income trust sectors. Gross underwriting and advisory revenue was up 11%, in large part due to near historical highs for M&A fees reflecting stronger activity in the Canadian resource sector. This was partially offset by lower equity originations reflecting less robust income trust activity and softer market conditions outside the resource sector. In 2006, we advised on 86 M&A deals with a total value of US$67 billion. This was up from 66 deals in the prior year. The increase largely reflected a robust Canadian M&A environment and solid growth in the U.S. market. In 2006, we led or co-led 82 equity and equity-related new issues with a total market value of $13 billion, up from 75 in the prior year. Increased volumes from the prior year was more than offset by reduced deal values, reflect- ing uncertainty in the markets outside the resource sector and a drop in income trust origination. RBC Dexia Investor Services RBC Dexia IS was created on January 2, 2006 when we combined our Institutional & Investor Services (IIS) business with Dexia Funds Services in return for a 50% joint venture interest in RBC Dexia IS. 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. 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 compara- tive 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 nine months ended September 30, 2006, as RBC Dexia IS reports on a one-month lag. Financial performance Revenue was $558 million in 2006, primarily reflecting high deposit volumes and strong foreign exchange revenue resulting from strong market activity. Since its creation on January 2, 2006, assets under administration have increased 9% reflecting strong market activity. Other Other consists of our other businesses including National Clients, which manages our client relationships with mid-market clients in Canada. It also includes our Global Credit business, which oversees the manage- ment of our core lending portfolios and manages our non-strategic lending portfolio. Global Credit also manages our Global Financial Institutions business which delivers innovative and creative solutions to global financial institutions including correspondent banking, treasury and cash management services. Research offers economic and securi- ties research products to institutional clients in Canada and globally. Selected highlights (1) (C$ millions) Total revenue (teb) (2) Other information Gross underwriting and advisory fees Equity sales and trading Other (3) 2006 2005 $ 1,250 $ 979 $ 665 283 302 598 252 129 Table 34 2004 941 546 247 148 (1) (2) (3) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. Other includes the gain on our NYSE shares, increases in private equity distributions and growth in revenue associated with our core lending book and syndicated finance. Gross underwriting and advisory fees, equity sales and trading, and Other revenue (C$ millions) 1,500 1,200 900 600 300 0 2004 2005 2006 Other Equity sales and trading Gross underwriting and advisory fees Selected highlights (1) Table 35 (C$ millions) $ Total revenue (teb) (2), (3) Other information Assets under administration – RBC (4) RBC Dexia IS (5) 2006 2005 2004 558 $ 500 $ 455 1,893,000 – 1,361,100 1,202,900 – – (1) (2) (3) (4) (5) Certain segment-related amounts have been restated to conform to our current manage- ment reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. Comparative amounts for 2005 and 2004 only represent revenue for IIS. Assets under administration – RBC represents total AUA of our IIS business. RBC IIS AUA of $1,400 billion was contributed to RBC Dexia IS in exchange for our 50% ownership interest. Assets under administration – RBC Dexia IS represents the total AUA of RBC Dexia IS. As RBC Dexia IS reports on a one-month lag basis, AUA – RBC Dexia IS is reported as at September 30, 2006. Financial performance Revenue from Other was $306 million, a decline of $21 million, or 6%, over the prior year. The decrease mainly reflected the gain recorded in the prior year related to the sale of an Enron-related claim. This factor was partially offset by increased revenue in our Global Financial Institutions business due to higher deposit balances. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 61 Corporate Support Corporate Support segment activities include our Global Technology and Operations Group, Corporate Treasury, Finance, Human Resources, Risk Management, Internal Audit and other Global Functions, the costs of which are largely allocated to the business segments. The reported results for the Corporate Support segment mainly reflect activities that are undertaken for the benefit of the organization which are not allocated to the business segments such as enterprise funding, securitization and the net charges associated with unattributed capital. The results also include consolidation adjustments such as the elimination of the teb adjustments recorded in RBC Capital Markets related to the gross-up of income from Canadian taxable corporate dividends to their tax equivalent value. These adjustments are recorded in net interest income and offset in the provision for income taxes. Due to the nature of activities and consolidated adjustments reported in this segment, we believe that a period over period trend analysis is not relevant. The following identifies the material items affecting the reported results in each period. Corporate Support financial highlights (1) (C$ millions) Net interest income (teb) (2) Non-interest income Total revenue (teb) (2) Non-interest expense Recovery of credit losses Business realignment charges Net income before income taxes and non-controlling interest in subsidiaries (teb) (2) Net income (loss) Selected average balance sheet and other information (3) Total assets Attributed capital (4) Securitization Total securitizations sold and outstanding (5) New securitizations activity in the period (6) Table 36 2006 2005 2004 (489) $ 180 (309) $ 37 (86) – (260) $ $ 112 (293) $ 188 (105) $ 61 (47) 39 (158) $ (14) $ (314) 268 (46) 28 (36) 64 (102) (61) (5,400) $ 3,150 (4,100) $ 2,800 (2,300) 1,600 $ $ $ $ $ 17,781 7,529 12,661 4,952 7,883 3,074 (1) (2) (3) (4) (5) (6) Certain segment-related amounts have been restated to conform to our current management reporting framework and changes made to our business segments during the year. For further discussion, refer to the How we manage our business segments section. Taxable equivalent basis. For further discussion, refer to the How we manage our business segments section. These amounts included the elimination of the adjustment related to the gross-up of income from Canadian corporate dividends of $213 million in 2006 recorded in RBC Capital Markets (2005 – $109 million; 2004 – $55 million). Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Average attributed capital is a non-GAAP financial measure. For further discussion, refer to the Key financial measures (non-GAAP) section. Total securitizations sold and outstanding are comprised of Credit card loans and Residential mortgages. New securitization activity is comprised of Residential mortgages and Credit card loans securitized and sold in the year. For further details, refer to Note 5 to our Consolidated Financial Statements. 2004 Net loss of $61 million primarily reflected the $64 million in business realignment charges, a $42 million charge for losses on equity invest- ments, a $68 million charge for consolidation adjustments to eliminate inter-company items such as underwriting fees, the $26 million writedown of an investment in AOL Canada and $19 million of costs relating to a processing disruption. These factors were partially offset by mark-to- market gains on derivatives related to certain economic hedges. 2006 Net income of $112 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 deriva- tives related to certain economic hedges also contributed to net income in the year. These factors were partially offset by the timing of securitiza- tion activity and an amount accrued related to a leased space which we will not occupy and expect to sub-lease at a rate lower than our contracted rate. 2005 Net loss of $14 million largely reflected business realignment charges of $39 million and mark-to-market losses on derivatives relating to certain economic hedges, which were partially offset by securitization activity and interest refunds relating to the resolution of disputed tax items for the 1993 to 1998 tax periods. Royal Bank of Canada Annual Report 2006 62 Management’s Discussion and Analysis Financial condition Balance sheet data and analysis (C$ millions) Interest-bearing deposits with banks Securities Trading account Investment account and loan substitutes Total securities Assets purchased under reverse repurchase agreements and securities borrowed Loans Residential mortgages Personal loans Credit cards Business and government loans Total loans Other assets Total assets Deposits Other liabilities Non-controlling interest in subsidiaries Shareholders’ equity Table 37 As at October 31 2006 2005 $ 10,502 $ 5,237 $ 147,237 37,632 $ 184,869 $ 59,378 $ 125,760 34,735 $ 160,495 $ 42,973 $ 96,675 44,902 7,155 61,207 $ 209,939 $ 69,100 $ 536,780 $ 343,523 $ 160,575 1,775 $ $ 22,123 $ 91,043 41,045 6,200 53,626 $ 191,914 $ 65,399 $ 469,521 $ 306,860 $ 131,003 1,944 $ $ 19,847 2006 vs. 2005 Total assets increased $67 billion, or 14%, from a year ago. The increase was largely attributable to higher Total securities and Assets purchased under reverse repurchase agreements and securities borrowed in support of our increased level of trading activities, and growth in Total loans reflecting strong loan demand driven by favourable economic conditions. Interest-bearing deposits with banks increased $5 billion from a year ago, mainly due to the consolidation of our 50% proportionate share in RBC Dexia IS. Credit cards increased $1 billion, or 15%, despite the offsetting effect of $550 million of net securitization during the year. The increase largely reflected successful sales efforts and strong growth in client spending and balances. The net securitization of $550 million was com- prised of $1.2 billion securitized in 2006 and $650 million of previously securitized amounts which matured in 2006, resulting in the loans being recorded back on our Consolidated Balance Sheets. Business and government loans were up $7 billion, or 13%, reflecting solid business loan demand and the consolidation of our 50% proportionate share in RBC Dexia IS. Total securities increased $24 billion, or 15%, from a year ago, mainly reflecting a higher level of trading securities in support of growth in our trading businesses. Other assets increased $4 billion, or 6%, from the prior year, primarily due to increased business activity in customers’ liability under acceptances and receivables from brokers and dealers. Assets purchased under reverse repurchase agreements and securities borrowed increased $16 billion, or 38%, from a year ago generally in support of equity and debt trading strategies and business expansion. Deposits increased $37 billion, or 12%, from a year ago, largely driven by growth in business and government deposits in support of increased business activities as well as increased funding requirements of our trading businesses. Total loans increased $18 billion, or 9%, from a year ago as a result Other liabilities increased $30 billion, or 23%, compared to the of increases across all categories, reflecting strong loan demand driven by favourable economic conditions. prior year, mainly due to increased business activities related to repur- chase agreements, securities lending and securities sold short. Residential mortgages increased $6 billion, or 6%, despite the offsetting effect of $13.6 billion of net securitization during the year. The increase continued to be driven by a relatively solid housing market, relatively low interest rates, strong labour market conditions, as well as continued consumer confidence. Our sales efforts also contributed to the increase. Personal loans increased $4 billion, or 9%, reflecting continued growth in both secured and unsecured credit lines, supported by strong consumer demand and favourable credit conditions. Shareholders’ equity was up $2 billion, or 11%, over the prior year on strong earnings growth, net of dividends. Details on our common and preferred share balances in our Shareholders’ equity and Preferred share liabilities are provided in Table 38. For further discussion, refer to Note 18 to our Consolidated Financial Statements. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 63 Share data and dividends Table 38 (C$ millions, except number of shares and per share amounts) Number of shares (000s) Amount Dividends per share Number of shares (000s) Amount Dividends per share Number of shares (000s) Amount Dividends per share 2006 2005 2004 First Preferred Non-cumulative Series N (1) Non-cumulative Series O (1) US$ Non-cumulative Series P Non-cumulative Series S Non-cumulative Series W (1) Non-cumulative Series AA (2) Non-cumulative Series AB (3) $ $ 12,000 6,000 – – 12,000 12,000 12,000 300 150 – – 300 300 300 $ 1.18 1.38 – 1.33 1.23 .71 .41 12,000 6,000 – 10,000 12,000 – – $ 300 150 – 250 300 – – $ 1.18 1.38 US 1.26 1.53 .99 – – 12,000 6,000 4,000 10,000 – – – 300 150 132 250 – – – Total First Preferred $ 1,350 $ 1,000 $ 832 Common shares outstanding (4) 1,280,890 (94) Treasury shares – preferred Treasury shares – common (4) (5,486) Stock options (4) Outstanding Exercisable 32,243 26,918 $ 7,196 (2) (180) $ 1.44 1,293,502 (91) (7,053) $ 7,170 (2) (216) $ 1.18 1,289,496 – (9,726) $ 6,988 – (294) 36,481 28,863 44,744 32,801 $ 1.18 1.38 US 1.44 1.53 – – – $ 1.01 (1) As at October 31, 2006, the aggregate number of common shares issuable on the conversion of the First Preferred Shares Series N and O was approximately 6,463,000 and 3,264,000, respec- tively. As at October 31, 2006, the First Preferred Shares Series W was not yet convertible. On November 24, 2006, we redeemed all the issued and outstanding Non-cumulative First Preferred Shares Series O. (2) On April 4, 2006, we issued 12 million First Preferred Shares Series AA. These preferred shares do not have a conversion option. (3) On July 20, 2006, we issued 12 million First Preferred Shares Series AB. These preferred shares do not have a conversion option. (4) On April 6, 2006, we paid a stock dividend of one common share on each of our issued and outstanding common shares. The effect is the same as a two-for-one split of our common shares. All common shares, treasury shares and stock option numbers have been retroactively adjusted to reflect the stock dividend. As at November 24, 2006, the number of outstanding common shares and stock options were 1,279,524,000 and 31,754,000 respectively. The number of other securities disclosed in the table above are unchanged. For further information, refer to Notes 18 and 21 to our Consolidated Financial Statements. On November 1, 2006, we issued 8 million First Preferred Shares Series AC. The net proceeds of this transaction will be used for general business purposes. Subject to regulatory approval, we may redeem these preferred shares in whole or in part at a declining premium on or after November 24, 2011. Capital management Capital management framework We actively manage our capital to balance the desire to maintain strong capital ratios and high ratings with the desire to provide strong returns to our shareholders. In striving to achieve this balance, we consider the requirements of regulators, rating agencies, depositors and share- holders, as well as our future business plans, peer comparisons and our position relative to internal targets for capital ratios. Additional con- siderations include the costs and terms of current and potential capital issuances and projected capital requirements. Our capital management framework serves to define, measure, raise and invest all forms of capital in a co-ordinated and consistent manner. We manage and monitor our capital from three perspectives: (i) regulatory capital, (ii) economic capital and (iii) subsidiary capital. This co-ordinated approach to capital management serves an important business function, optimizing our capital usage and structure. It pro- vides more efficient support for our business segments and clients and better returns to 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, including all capital transactions, in conjunction with our operating plan. The Audit Committee is responsible for the gover- nance of capital management, which includes the review and ongoing monitoring of internal controls and the control environment as well as establishing and approving policies for their compliance with regulatory standards and internal objectives. The Asset and 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. In addition, the OSFI meets with our Audit Committee and the Conduct Review and Risk Policy Committee to discuss our policies and procedures regarding capital management. Capital Management is responsible for the design and imple- mentation of policies for regulatory, economic and subsidiary capital management. Other key responsibilities include the monitoring and reporting of our capital position along with recommending and co-ordinating the execution of capital transactions. Royal Bank of Canada Annual Report 2006 64 Management’s Discussion and Analysis Risk-adjusted assets Risk-adjusted assets are determined by applying the OSFI prescribed rules to on-balance sheet and off-balance sheet exposures. They also include an amount for the market risk exposure associated with our trading portfolios. Over the last year, risk-adjusted assets increased by $27 billion to $224 billion, largely due to strong growth in loans, investment securities and residential mortgages. Strong growth in off-balance sheet credit instruments as well as the impact of RBC Dexia IS also contributed to the increase. Risk-adjusted assets for market risk declined from the previous year. Risk-adjusted assets (1) (C$ millions, except percentage amounts) Balance sheet assets Cash and deposits with banks Securities Issued or guaranteed by Canadian or other OECD (3) governments Other Residential mortgages (4) Insured Conventional Other loans and acceptances (4) Issued or guaranteed by Canadian or other OECD (3) governments Other Other assets Off-balance sheet financial instruments Credit instruments Guarantees and standby letters of credit Documentary and commercial letters of credit Securities lending Commitments to extend credit Liquidity facilities Note issuance/revolving underwriting facilities Derivatives (5) Total off-balance sheet financial instruments Total specific and general risk Total risk-adjusted assets (1) (2) (3) (4) (5) Calculated using guidelines issued by the OSFI. Represents the weighted average of counterparty risk weights within a particular category. OECD stands for Organisation for Economic Co-operation and Development. Amounts are shown net of allowance for loan losses. Includes non-trading credit derivatives given guarantee treatment for credit risk capital purposes. Balance sheet amount Weighted average of risk weights (2) Table 39 Risk-adjusted balance 2006 2005 $ 15,392 15% $ 2,322 $ 1,830 25,120 159,749 29,666 66,996 20,501 159,730 59,623 $ 536,777 Credit equivalent amount $ 19,428 143 38,185 19,666 4,413 4 $ 81,839 43,498 $ 125,337 – 5% 1% 42% 19% 67% 18% 42 7,811 48 5,278 363 27,921 385 25,592 3,848 107,336 10,609 2,991 95,639 7,014 $ 160,252 $ 138,777 73% 45% 8% 85% 100% 100% $ 14,092 65 3,022 16,666 4,413 4 $ 12,154 56 2,299 14,968 3,513 3 $ 38,262 $ 32,993 24% 10,432 9,696 $ 48,694 $ 42,689 14,763 15,538 $ 223,709 $ 197,004 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 of International Settlements. Regulatory capital is allocated into two tiers, with Tier 1 capital comprising the more permanent components of capital. Tier 1 capital consists primarily of common shareholders’ equity, non-cumulative preferred shares, and the eligible amount of innovative capital instruments less a deduction for goodwill. Tier 2 capital consists mainly of subordinated debentures, 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. Regulatory capital ratios are calculated by dividing Tier 1 and Total capital by risk-adjusted assets based on GAAP financial information. In 1999, the OSFI formally established risk-based capital targets for deposit-taking institutions in Canada. These targets are 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 need to operate within a leverage constraint and ensure that their assets-to-capital multiple, which is calculated by dividing gross adjusted assets by Total capital, does not exceed the level prescribed by regulators. The components of regulatory capital and our regulatory capital ratios are shown in Table 40. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 65 Regulatory capital and capital ratios (1) (C$ millions, except percentage amounts) Tier 1 capital Common equity (2) Non-cumulative preferred shares Innovative capital instruments Other non-controlling interest in subsidiaries Goodwill Tier 2 capital Permanent subordinated debentures (3) Non-permanent subordinated debentures (3) Innovative capital instruments General allowances Other deductions from capital Investment in insurance subsidiaries Other Total capital Capital ratios Tier 1 capital to risk-adjusted assets Total capital to risk-adjusted assets Assets-to-capital multiple Table 40 2006 2005 $ 21,065 1,345 3,222 28 (4,182) $ 19,115 997 2,835 28 (4,074) 21,478 18,901 839 6,313 249 1,223 8,624 874 7,234 567 1,286 9,961 (2,795) (643) (2,642) (407) $ 26,664 $ 25,813 9.6% 11.9% 19.7X 9.6% 13.1% 17.6 X (1) (2) (3) As defined in the guidelines issued by the OSFI. This amount is shareholders’ equity less preferred shares of $1,050 million and other items of $8 million. 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. Tier 1 capital ratio 9.3% 9.7% 8.9% 9.6% 9.6% 12% 9% 6% 3% 0% 2002 2003 2004 2005 2006 Tier 1 capital rose to $21.5 billion, an increase of $2.6 billion over last year. The increase was primarily due to strong internal capital genera- tion, the reclassification of innovative capital from Tier 2 and the net issuance of preferred shares as outlined in the capital management activity section below. These increases were partially offset by common share repurchases and cumulative unrealized foreign currency transla- tion losses as a result of a stronger Canadian dollar. Tier 2 capital decreased $1.3 billion in 2006. The decrease was mainly a result of redemptions of subordinated debentures as outlined in the capital management activity section below and the reclassification of innovative capital to Tier 1. Total capital increased $.9 billion as the net increase in Tier 1 and Tier 2 capital was partially reduced by an increase in regulatory deductions. As at October 31, 2006, the Tier 1 capital ratio of 9.6% was unchanged from a year ago as strong internal capital generation, the reclassification of innovative capital from Tier 2 and the net issuance of preferred shares were offset by share repurchases and strong balance sheet growth. The Total capital ratio of 11.9% was down 120 bps from the previous year largely reflecting our redemption of subordinated debentures in 2006. Throughout fiscal 2006, we maintained a Tier 1 cap- ital ratio that exceeded our 2006 annual objective of greater than 8%. As at October 31, 2006, our assets-to-capital multiple was 19.7 times, which remained below the maximum permitted by the OSFI, compared to 17.6 times as at October 31, 2005. Royal Bank of Canada Annual Report 2006 66 Management’s Discussion and Analysis Selected capital management activity (C$ millions) Dividends Common Preferred Preferred shares issued Preferred shares redeemed Treasury shares net sales – common Repurchase of common shares – normal course issuer bid (1) Repurchase and redemption of debentures (2) Issuance of Trust Capital Securities (3) (1) (2) (3) For further details, refer to Note 18 to our Consolidated Financial Statements. For further details, refer to Note 16 to our Consolidated Financial Statements. For further details, refer to Note 17 to our Consolidated Financial Statements. $ Table 41 2006 2005 $ 1,847 60 600 (250) 36 (844) (955) – 1,512 42 300 (132) 132 (226) (786) 1,200 In 2006, we undertook several initiatives to effectively manage our capital. On April 26, 2006, we redeemed all of our $100 million of outstand- Tier 1 In 2006, we repurchased 13.8 million common shares for $844 million, of which 6.6 million shares were repurchased for $311 million under our normal course issuer bid (NCIB) that expired on October 31, 2006; and 7.2 million shares were repurchased for $533 million under our NCIB that expired on June 23, 2006. Effective November 1, 2006, we renewed our NCIB to repurchase up to 40 million common shares, or 3%, of our outstanding common shares. This NCIB will expire on October 31, 2007. On October 6, 2006, we redeemed all of the issued and outstand- ing $250 Non-cumulative First Preferred Shares Series S. On July 20, 2006, we issued $300 million of Non-cumulative First Preferred Shares Series AB at $25 per share. On April 6, 2006, we paid a stock dividend of one common share for each issued and outstanding common share, which has the same effect as a two-for-one split of our common shares. On April 4, 2006, we issued $300 million of Non-cumulative First Preferred Shares Series AA at $25 per share. Subsequent to October 31, 2006, we completed the following capital- related activities: On November 1, 2006, we issued $200 million of Non-cumulative First Preferred Shares Series AC at $25 per share. On November 24, 2006, we redeemed all of the issued and out- standing $150 million Non-cumulative First Preferred Shares Series O. Tier 2 During the year, we purchased $22 million of the outstanding $250 million floating-rate debentures maturing in 2083 and US$19 million of the outstanding US$300 million floating-rate deben- tures maturing in 2085. On October 24, 2006, we redeemed all of our US$300 million of outstanding 6.75% subordinated debentures due October 24, 2011, for 100% of their principal amount plus accrued interest. On September 12, 2006, we redeemed all of our $350 million of outstanding 6.50% subordinated debentures due September 12, 2011, for 100% of their principal amount plus accrued interest. Starting in the third quarter of 2006, we included in our Tier 2B capital US$120 million junior subordinated debentures issued by RBC Centura prior to acquisition in 2001 based on the OSFI’s approval. The ongoing inclusion of these instruments in our Tier 2B capital and any redemption or repurchase is subject to certain regulatory conditions. ing 8.20% subordinated debentures due April 26, 2011, for 100% of their principal amount plus accrued interest. On February 13, 2006, we redeemed all of our $125 million of outstanding 5.50% subordinated debentures due February 13, 2011, for 100% of their principal amount plus accrued interest. Subsequent to October 31, 2006, we completed the following capital- related activity: 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 2006 was 40–50%. In 2006, the dividend pay- out ratio was 40%, down from 45% in 2005. Common share dividends during the year were $1.8 billion, up 22% from a year ago. Hedging foreign currency-denominated operations Rising U.S. dollar-denominated assets and deductions from regulatory capital have prompted the development of a policy regarding hedging our foreign exchange exposure with respect to our foreign operations. The objectives of our hedging policy are: (i) immunization of our consolidated regulatory capital ratios from currency fluctuations and (ii) mitigation of potential earnings volatility that might result at disposition of these investments. When the Canadian dollar strength- ens/weakens against other currencies, the losses/gains on net foreign investments reduce/increase our capital, as well as the risk-adjusted assets and goodwill of the foreign currency-denominated operations. By selecting an appropriate level of hedging of our investment in foreign operations, our regulatory capital ratios are not materially impacted by currency fluctuations due to the offsetting impact of the proportionate movement in the assets and capital. The outcome of hedging operations denominated in foreign currencies is to promote orderly and efficient capital management. It enables us to comply with regulatory requirements on an ongoing basis and to maintain greater control over key capital ratios thereby reducing the need for capital transactions in response to currency fluctuations. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 67 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 condi- tions, given our desire to maintain an AA debt rating. Economic capital is attributed to each business segment in proportion to the risks inherent in their respective business and drives the optimization of returns in terms of risk and reward. It allows for direct comparable performance measurements through Return on equity (ROE) and Return on risk capital (RORC) which are described in detail in the Key financial measures (non-GAAP) 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. The identified risks for which we calculate Economic capital are credit, market (trading and non-trading), operational, business, fixed asset and insurance risk. • Credit risk is the risk of loss associated with a counterparty’s inability to fulfill its payment obligations. • Market risk is the risk of loss that results from changes in interest and foreign exchange rates, equity and commodity prices and credit spreads. • • • • Operational risk is defined as 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 actuarial assumptions made in insurance product design and pricing activities differ from actual experience. In addition, goodwill and intangibles are underpinned by Economic capital. For further discussion of credit, market, operational and insur- ance risk, refer to the Risk management section. Economic capital is a non-GAAP measure and its calculation and attribution 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 (C$ millions average balances) Credit risk Market risk (trading and non-trading) Operational risk Business and fixed asset risk Insurance risk Risk capital Goodwill and intangibles Attributed capital (Economic capital) Unattributed capital Common equity $ 2006 5,800 2,500 2,450 1,800 200 $ Table 42 2005 5,100 2,200 2,350 1,600 200 $ 12,750 4,650 $ 11,450 4,850 $ 17,400 2,500 $ 16,300 2,300 $ 19,900 $ 18,600 Attributed Economic capital increased $1.1 billion from the same period a year ago largely due to increases in Credit risk and Market risk capital partially offset by a decrease in Goodwill and intangibles. The increase in Credit risk capital was primarily due to business growth along with the impact of RBC Dexia IS, which was established on January 2, 2006. Market risk capital increased largely in our non-trading portfolios. Goodwill and intangibles decreased as a result of the impact of a stron- ger Canadian dollar on the translated value of U.S. dollar-denominated assets and was partially offset by the impact of RBC Dexia IS and Abacus. We remain well capitalized with current levels of qualified equity exceeding the Economic capital required to underpin all of our risks. Subsidiary capital Structured management of consolidated capital has become a key stra- tegic objective as the amount of capital deployed in subsidiaries to build their businesses has grown in order to maximize profits and returns to 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. To meet these new regulatory requirements and facilitate the co-ordinated generation and allocation of capital across the organization, we have put in place a comprehensive subsidiary capital framework. This framework sets guidelines for defining capital investments in our subsidiaries and establishes minimum targets in relation to our 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, the Capital Management Group is mandated to provide centralized oversight and consolidated capital base management across various entities. Future developments We closely monitor changes in the accounting framework and their potential impact on our capitalization levels through ongoing dialogue with our external auditors, other financial institutions, the Canadian Bankers Association and the OSFI. Several changes in accounting principles have either been introduced or are being proposed in the areas of financial instruments (as described in the Critical accounting policies and estimates section and Note 1 to the Consolidated Financial Statements), and requirements for contracts that can be settled in cash or shares to be settled in shares for the calculation of diluted EPS. These changes could affect our capital requirements and activities. Basel II The implementation of the capital adequacy requirements for Basel II will begin with a parallel run in fiscal 2007 with full compliance expected at the beginning of fiscal 2008. We are actively preparing for the imple- mentation of the Basel II framework as detailed in the Risk management section. Royal Bank of Canada Annual Report 2006 68 Management’s Discussion and Analysis 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 man- agement, capital management and/or funding management purposes for our benefit and the benefit of our clients. These transactions include derivative financial instruments, transactions with special purpose entities and issuance of guarantees. These transactions give rise to, among other risks, varying degrees of market, credit and liquidity risk, which are discussed in the Risk management section. Derivative financial instruments Derivative financial instruments are primarily used in sales and trading activities to enable our clients to transfer, modify or reduce current or expected risks. These trading derivatives are fully recognized at their fair values on our Consolidated Balance Sheets. We also use derivatives to manage our exposures to interest, currency, credit and other market risks. We may choose to 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 (economic hedges). These economic hedges are also carried at fair value on our Consolidated Balance Sheets. interests. Pursuant to the 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 man- agement section for further details. Securitization of our financial assets We periodically securitize our credit card receivables and residential and commercial mortgage loans primarily to diversify our funding sources and enhance our liquidity position. Gains and losses on securitizations are included in Non-interest income. Credit card receivables We securitize a portion of our credit card receivables through an SPE on a revolving basis. The SPE is funded through the issuance of senior and subordinated notes collateralized by the underlying credit card receivables. 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. Certain derivatives that are used to manage our risks are specifi- We continue to service the credit card receivables sold to the QSPE cally designated and qualify for hedge accounting (accounting hedges). We apply hedge accounting to minimize significant unplanned fluctua- tions in earnings caused by changes in interest rates or exchange rates. These hedging derivatives represent off-balance sheet items, as they are not carried at fair value. Notes 1 and 7 to our Consolidated Financial Statements provide more detail on our accounting for, and types of, derivatives. The follow- ing are the net fair values of the derivatives by category: Derivatives (C$ millions) On-balance sheet Trading derivatives Economic hedges Off-balance sheet Accounting hedges Total net fair value Table 43 2006 2005 $ (4,222) $ (498) (3,628) (452) 294 386 $ (4,426) $ (3,694) 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 oper- ating entities and usually have no employees. SPEs may be variable interest entities (VIEs) as defined by the Canadian Institute of Chartered Accountants (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 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 obliga- tion 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 Investment account 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 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 mortgages underlying these MBS. The retained portion of these MBS is recorded in Investment account securities on our Consolidated Balance Sheets. Commercial mortgage loans We securitize commercial mortgages by selling them in collateral pools, which meet certain diversification, leverage and debt coverage criteria, to an SPE. The SPE finances the purchase of these pools by issuing certificates that carry varying degrees of subordination. These certifi- cates range from AAA to B- when rated, and the most subordinated are unrated. The certificates represent undivided interests in the collateral pool, and the SPE, having sold all undivided interests available in the pool, retains none of the risk of the collateral pools. As part of the SPE pooling and servicing agreement, we continue to be the primary servicer of the loans under contract with a master servicer for the SPE. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 69 Our financial asset securitizations (C$ millions) Outstanding securitized assets Residential mortgages Credit cards Commercial mortgages Total Retained interests Residential mortgages Mortgage-backed securities retained Retained rights to future excess interest Credit cards Asset-backed securities purchased Retained rights to future excess interest Subordinated loan receivables Total Table 44 2006 2005 $ $ 14,131 3,650 1,914 9,561 3,100 1,237 $ 19,695 $ 13,898 $ 5,591 206 1,390 26 6 $ 2,654 172 596 21 6 $ 7,219 $ 3,449 2006 vs. 2005 During the year, we securitized $13.6 billion of residential mortgages, of which $6.3 billion were sold and the remaining $7.3 billion were retained as Investment account securities. We also securitized $.7 billion of commercial mortgages and $1.2 billion in credit card loans. During the year, $650 million of previously securitized credit card loans matured which resulted in the loans being recorded back on our Consolidated Balance Sheets. For further details, refer to Note 5 to our Consolidated Financial Statements. Capital trusts We issue innovative capital instruments, RBC Trust Capital Securities (TruCS), through two SPEs: RBC Capital Trust (Trust) and RBC Capital Trust II (Trust II). We consolidated Trust but did not consolidate Trust II. As at October 31, 2006, we held the residual interest of $1 million (2005 – $1 million) in Trust II, had a loan receivable from Trust II of $42 million (2005 – $44 million), and reported the senior deposit note of $900 million (2005 – $900 million) we issued to Trust II in our deposit liabilities. Under certain circumstances, TruCS of Trust II will be auto- matically exchanged for our preferred shares. 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 note issued to Trust II amounted to $52 million (2005 – $52 million; 2004 – $52 million) during the year. For further details on the capital trusts and the terms of the TruCS 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 six multi-seller asset-backed commercial paper conduit programs (multi-seller conduits) – 3 in Canada and 3 in the United States. We are involved in the multi-seller conduit markets because our clients value these transactions, they offer 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 securitiza- tion 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. During 2006, the multi-seller conduits also financed assets that were in the form of either securities or instruments that closely resemble securities such as credit-linked notes. The credit quality of these transactions was very high – often in the highest available rating cat- egories 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 liquid- ity 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 structur- ing 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. 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 $60 million during the year (2005 – $58 million; 2004 – $70 million). At fiscal years ended October 31, total commitments and amounts outstanding under liquidity and credit enhancement facilities for the multi-seller conduits, which are also included in our discussion in the Guarantees section, are shown below: Liquidity and credit facilities Table 45 2006 2005 (C$ millions) Committed (1) Outstanding Committed (1) Outstanding Liquidity facilities $ 34,880 $ Credit facilities 3,404 – $ 29,442 $ – 2,832 – – (1) Our maximum exposure to loss under these facilities is $35.1 billion for 2006 and $29.4 billion for 2005. The increase in liquidity facilities is due to the increase in the multi-seller conduits’ activities during the year. 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 the year, these six multi-seller conduits have financial assets totalling $24.8 billion as at October 31, 2006 (2005 – $20.2 billion). The maximum assets that may have to be purchased by the conduits under purchase commitments outstanding as at October 31, 2006 were $34.3 billion (2005 – $29.3 billion). Royal Bank of Canada Annual Report 2006 70 Management’s Discussion and Analysis Creation of credit investment products We use SPEs to generally transform credit derivatives into cash instru- ments, 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 gener- ally 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 on occasion act as market maker. We do not, however, provide any SPE with any guarantees or other similar support commitments; rather, we buy credit protection from these SPEs through credit derivatives. The inves- tors 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 trad- ing derivatives, the derivatives with these SPEs are carried at fair value in derivative-related assets and liabilities. The assets in these SPEs amounted to $3.8 billion as at October 31, 2006 (2005 – $3.3 billion), of which $.7 billion were consolidated as at October 31, 2006 (2005 – $.7 billion). Asset management Collateralized Debt Obligation (CDO) SPEs raise capital by issuing debt and equity securities and invest their capital proceeds in portfolios of debt securities. Any net income or loss is shared by the CDO’s equity and debt investors. In 2005, we sold our CDO management business to a third party, and in 2006, we sold our investments in the CDO’s first- loss tranche. The interest income from investments in the CDO’s first-loss tranche totalled nil in 2006 (2005 – $9 million; 2004 – $10 million). Structured finance We occasionally make loan substitute and equity investments in off-balance sheet entities 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 after-tax 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 regu- lations. We consolidate structured finance VIEs in which our interests expose us to a majority of the expected losses. The unconsolidated entities in which we have significant investments or loans had total assets of $6.9 billion as at October 31, 2006 (2005 – $6.5 billion). As at October 31, 2006, our total investments in and loans to these entities were $2.9 billion (2005 – $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 expo- sure 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 sig- nificant exposure and which we did not consolidate were $3.6 billion (2005 – $6.7 billion) as at October 31, 2006. As at October 31, 2006, our total exposure to these funds was $319 million (2005 – $908 million). The total assets held in the funds where we have significant exposure declined as we have sold some of our investments in these funds. Trusts, mutual and pooled funds Our joint venture RBC Dexia IS provides trusteeship and/or custodian services for a number of personal and institutional trusts and has a fidu- ciary responsibility to act in the best interests of the beneficiaries of the trusts. RBC Dexia IS earns fees for providing these services. We include 50% of these fees in our revenue, representing our share of interest in RBC Dexia IS. 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 prod- ucts 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. Our maximum potential amount of future payments in relation to our guarantee products as at October 31, 2006, amounted to $125 billion (2005 – $121 billion). In addition, as of October 31, 2006, RBC Dexia IS securities lending indemnifications totalled $45.6 billion (2005 – nil); we are exposed to 50% of this amount. The maximum potential amount of future payments represents the maximum risk of loss if there were a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions, insurance policies or from collat- eral held or pledged. Note 27 to our Consolidated Financial Statements provides detailed information regarding the nature and maximum potential expo- sure for the above-mentioned types of guarantee products. In addition to guarantees, we provide commercial commitments to our clients to help them meet their financing needs. On behalf of our clients we undertake written documentary and commercial letters of credit, authorizing a third party to draw drafts on us up to a stipulated amount and typically having underlying shipments of goods as collat- eral. We make commitments to extend credit, which represent unused portions of authorizations to extend credit in the form of loans, bankers’ acceptances or letters of credit. We also have uncommitted amounts for which we retain the option to extend credit to a borrower. The following is a summary of our off-balance sheet commercial commitments. Commercial commitments (1) Table 46 (C$ millions) Within 1 year 1 to 3 years Over 3 to 5 years Over 5 years Total Documentary and commercial letters of credit Commitments to extend credit and liquidity facilities Uncommitted amounts (2) $ 693 45,171 45,498 $ 20 29,736 – $ – 20,279 – $ – 4,190 – $ 713 99,376 45,498 $ 91,362 $ 29,756 $ 20,279 $ 4,190 $ 145,587 (1) (2) Based on remaining term to maturity. Uncommitted amounts represent an amount for which we retain the option to extend credit to a borrower. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 71 Credit risk is the risk of loss associated with a counterparty’s inability to fulfill its payment obligations. Market risk is the risk of loss that results from changes in interest and foreign exchange rates, equity and commodity prices, and credit spreads. Liquidity and funding risk is the risk that an institution is unable to generate sufficient cash or its equivalent in a timely and cost-effective manner to meet its commitments as they come due. 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. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Reputation risk is the risk that an activity undertaken by an orga- nization 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. Strategic risk is the risk that the enterprise or a particular business area will make inappropriate strategic choices, or is unable to success- fully implement selected strategies or related plans and decisions. 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 adhere to or comply with regulations, law, industry codes or rules, regulatory expectations or ethical standards. Competitive risk is the risk associated with the inability to build or maintain sustainable competitive advantage in a given market or markets. Systemic risk is the risk that the financial system as a whole may not withstand the effects of a crisis resulting from extraordinary eco- nomic, political, social or financial circumstances. This could result in financial, reputation or other losses. Environmental risk is the risk of loss to financial, operational or reputation value resulting from the impact of environmental issues. Environmental risk is often embedded within other risks such as credit and operational risk. Risk management Our business activities expose us to a wide variety of risks, which are inherent in virtually all aspects of our operations. Our goal in managing these risks is to protect the enterprise from an unacceptable level of earnings volatility while supporting and enabling business oppor- tunities. We do this by ensuring that the risks arising from 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 an effective risk management framework. The cornerstone of our risk management framework is a strong risk management cul- ture, 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 with our risk appetite. Risk management principles We apply the following overarching principles in the identification, monitoring and management of risk throughout the organization: • Business management is accountable for all risks assumed in their operations. Independent oversight is necessary to provide an objective assessment of our exposure to risk. The optimum balance of risk and return is achieved through the alignment of business strategy and risk appetite on an enterprise- wide basis. Extreme positions are avoided to mitigate the likelihood of unacceptable earnings volatility. • • • Risk types We have the greatest level of direct control and influence over credit, market, liquidity and funding, insurance and operational risks. Effective management of these risks reduces our exposure to other risks that we have less control and influence over. Risk types Systemic Regulatory and Legal Competitive Strategic Reputation Operational M o r e c o n t r o l a n d i n f l u e n c e Less control and influence Credit Market Liquidity and Funding Insurance Royal Bank of Canada Annual Report 2006 72 Management’s Discussion and Analysis Governance The following graphic illustrates our overall risk governance structure. Board and its committees Board of Directors Conduct Review and Risk Policy Committee Audit Committee Key risk committees Group Risk Committee USA Corporate Governance Committee Structured Transactions Oversight Committee Policy Review Committee Ethics and Compliance Committee Asset and Liability Committee Key risk management groups Group Risk Management and Corporate Treasury Business segments and corporate support groups Business Segments Global Technology and Operations Global Functions The responsibilities of the various stakeholders of risk management are as follows: Board and its committees Board of Directors The Board of Directors provides oversight and carries out its mandate with respect to risk management through the Conduct Review and Risk Policy Committee (CR&RPC) and the Audit Committee. Conduct Review and Risk Policy Committee (CR&RPC) This committee is designed to ensure that we have risk policies, pro- cesses and controls in place to manage the significant risks to which we are exposed and that we comply with the Bank Act (Canada) and other relevant laws and regulations. Key responsibilities are to (i) shape and influence our risk culture, (ii) identify risks, (iii) determine the appropri- ate organizational structure for Group Risk Management (GRM), (iv) review and approve significant policies and limits for controlling risk, (v) review and monitor the major risks we assume or face and provide direction as required, and (vi) ensure we have sufficient and appropriate risk management resources. Audit Committee The committee mandate includes (i) providing oversight over the integrity of the financial statements, (ii) ensuring policies related to liquidity and funding management and capital management are in place, and (iii) obtaining reasonable assurance that applicable policies are being adhered to. The committee reviews the adequacy and effectiveness of internal controls and regularly reviews regulatory and legal risks, and litigation matters that could significantly affect the financial statements. The committee, along with the CR&RPC, regularly reviews significant risks facing the organization and regulatory compliance matters. Key risk committees Group Risk Committee (GRC) The GRC executes management’s oversight role regarding risk man- agement. This committee is designed to ensure that the appropriate authorities, resources, responsibilities and reporting are in place to support an effective risk management program. The GRC is chaired by the President and Chief Executive Officer, and includes the other members of the Group Executive, the Chief Risk Officer and the Chief Financial Officer. The GRC is responsible for ensuring that (i) our overall risk profile is consistent with strategic objectives, and (ii) there are ongoing, appropriate and effective risk management processes to iden- tify, measure and manage risks on an aggregate basis. GRC recommends risk limits and controls including aggregate exposure limits for credit, market and insurance risks to CR&RPC for approval. In addition, it recommends the liquidity and funding management framework, liquidity contingency plan, and liquidity and funding risk limits to the Audit Committee for approval. We also have five primary management risk committees, which report to the GRC and ensure appropriate governance and compliance is maintained. The risk committee structure and mandates are reviewed regularly to ensure ongoing alignment with organizational roles and responsibilities and regulatory developments as necessary. The commit- tees are as follows: USA Corporate Governance Committee is responsible for oversight, monitoring and reporting on all corporate governance matters including all material risks, affecting our U.S. operations. Structured Transactions Oversight Committee provides risk over- sight of structured transactions and complex credits to ensure that all potentially significant reputation, regulatory and legal, accounting or tax risks are adequately identified and effectively managed or mitigated. Policy Review Committee is responsible for the approval of (i) our risk management and policy framework, (ii) enterprise-wide risk policies relating to risk identification and approval, measurement, controls, limits and reporting, (iii) new or changed products, services and initiatives with significant risk implications, and (iv) risk measurement approaches and methodologies. Ethics and Compliance Committee directly supports our manage- ment of regulatory, compliance and reputation risk through approval of our ethics and compliance program, which includes our Code of Conduct and Enterprise Compliance Management Framework, as well as specific policies and procedures in areas such as anti-money laundering and anti-terrorist financing, privacy and information protection, conflicts of interest, and insider trading. It serves as the senior management focal point in initiating response to and action on new and changing regula- tory and compliance risks. It informs and advises GRC and the Board of Directors on significant compliance and regulatory issues and appro- priate remedial measures. Asset and Liability Committee (ALCO) based on its delegated authority reviews, recommends or approves broad policy frameworks pertaining to economic and regulatory capital management, interest rate risk related to traditional non-trading banking activities, funds transfer pricing, liquidity and funding, as well as subsidiary governance. The committee also provides regular oversight and strategic direction in light of expected returns and the impact of competitive and regulatory environments. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 73 Key risk management groups Group Risk Management (GRM) GRM works in full partnership with our businesses to identify, assess, mitigate and monitor all forms of risk. The CRO has overall responsibil- ity for all aspects of the group risk management function. The CRO and GRM have been delegated responsibility by the Board of Directors for developing and maintaining (i) a comprehensive risk identification and approval process, (ii) appropriate methodologies for risk measurement, (iii) risk controls and limits to ensure appropriate risk diversification and optimization of risk/return on both a portfolio and transactional basis, and (iv) comprehensive and timely reporting to senior management and the Board on major risks being assumed by or facing the organization. Corporate Treasury The Corporate Treasury function has responsibility for the management, oversight and reporting of our capital position, structural interest rate risk, and liquidity and funding risks. Their responsibilities also include the management and reporting of regulatory, economic and subsidiary capital, while ensuring compliance with regulatory and internal con- straints. One of their goals is to optimize returns to shareholders by minimizing the cost of capital, within the above constraints. Corporate Treasury also recommends related policies and authorities to ALCO and GRC, who recommend to the Audit Committee for approval. Business segments and corporate support groups The business segments, Global Technology and Operations (GTO) and Global Functions also have responsibility for the management of risk. These responsibilities include (i) accountability of their risks, (ii) align- ment of business strategy with corporate risk culture and risk appetite, and (iii) identification, control and management of their risks. Risk measurement The 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 may only apply to a single risk type. While quantitative risk measurement is important, we also place reliance on qualitative factors. For each risk, where appropri- ate, controls are in place to ensure both quantifiable and unquantifiable risks are identified, assessed and reported. In most cases we are able to develop a quantifiable measure of expected loss and unexpected loss, as well as to conduct stress scenar- ios. These measurement models and techniques are continually subject to independent assessment for appropriateness and reliability. The implementation of Basel II will enhance our ability to measure risks. 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 they are within our risk tolerance. Expected loss Expected loss represents those losses that are statistically expected to occur as a result of conducting business. They largely arise in the form of credit and fraud losses due to lending activities. Unexpected loss Unexpected loss is a statistical estimate of the amount by which actual losses can exceed expected loss over a specified time horizon, mea- sured to a specified level of confidence. On an enterprise-wide basis, we use economic capital to quantify the unexpected loss associated with our business activities. Economic capital is computed and assigned by the various risk categories to the business activities. This enables the application of a common and consistent quantifiable metric to ensure that returns throughout the organization are commensurate with the associated risks. This represents best practice as it measures risk in terms of economic realities rather than regulatory or accounting rules. The use of economic capital as a risk metric enables us to assess per- formance on a more comparable risk-adjusted basis at the transaction and portfolio level. Economic capital is embedded in the management culture of the organization through risk-adjusted performance measures such as Return on equity and Return on risk capital. Royal Bank of Canada Annual Report 2006 74 Management’s Discussion and Analysis Stress scenario loss Stress testing helps determine the effects of potentially extreme market movements. Stress scenarios are conservatively based on unlikely but possible adverse market events and economy-wide developments. Through stress testing, we can assess the level of our potential risk exposure under extreme conditions. This type of testing is intended to alert senior management to our exposure to potential economic, politi- cal or other disruptive events in order to assess overall capital adequacy and the necessary action required. Model validation To ensure robustness of our measurement techniques, validation is carried out by risk professionals independent of those responsible for the development and usage of the models and assumptions. Risk control A comprehensive set of risk controls supports our enterprise-wide risk management approach. This includes the development and commu- nication 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 transactional basis. Policies Our Risk Policy Management Framework outlines the roles and responsi- bilities of GRM, the business segments and corporate support groups in the effective creation, approval, maintenance and communication of both enterprise-wide risk policies as well as business-specific risk policies. This risk policy management framework is supplemented with the policy approval authorities matrix which sets out who can approve policies, procedures, standards and guidelines. Risk policies that cover risk identification, measurement, man- agement and reporting are set by GRM and are considered minimum requirements for the businesses, GTO and other Global Functions. These policies communicate our risk appetite, limits and parameters within which business groups and employees can operate. Businesses also have specific policies and procedures in place to manage the risks within their business. All risk policies are subject to a rigorous approval process, which depending on the type and significance of the policy can involve the Policy Review Committee, Ethics and Compliance Committee, Group Risk Committee or the Conduct Review and Risk Policy Committee. Risk review and approval 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 origina- tor. The approval responsibilities are governed by delegated authorities. Requirements for the review and monitoring of risks are set out in a number of enterprise level policies and procedures. This includes but is not limited to the following: Credit Principles, Rules and Guidelines, Market Risk Principles and Rules, Operational Risk Policies as part of the Operational Risk Management Framework and compliance policies as part of the Enterprise Compliance Management Program Framework. The risk review and approval of new products and services is a key responsibility of GRM, with enterprise-wide requirements set out in the Policy and Procedures for the Approval of New or Amended Products and Services. This policy has been developed to ensure that our prod- ucts and services are subject to a broad and robust review and approval process that fully considers associated risks, while striving to facilitate business opportunities. Authorities and limits The Board of Directors, through the CR&RPC, delegates credit, market and insurance risk exposures to the President and Chief Executive Officer (CEO), Chief Operating Officer (COO) and Chief Risk Officer (CRO). The 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 authorities are reviewed and approved annually by the Board. • • 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. The establishment and maintenance of a sound risk limits system is fun- damental to the overall management of risks inherent in our business activities. The size of our limits reflects our risk appetite given market and credit conditions and our business strategies. Our policy on risk limits primarily covers and prevents the concen- tration of risk in the following areas: • • • • • Market risk. Single name risk (credit and transactional) Geographic and industry sector risk Product and portfolio risk Underwriting risk These identified limits apply consistently across all businesses, port- folios, transactions and products. Activities must be conducted within these limits. Those activities that exceed the specified limits are required to abide by the exception process as outlined within the policy. CR&RPC must approve any transactions which exceed management’s delegated authorities. Credit risk The OSFI expects each major bank in Canada to adopt the Advanced Internal Ratings Based Approach (AIRB) for all of its material portfolios, although some flexibility is permitted regarding the timing of adoption. AIRB, which is the most sophisticated of the three approaches, involves an extensive and rigorous supervisory approval process to ensure that the bank complies with a comprehensive set of minimum standards. Once approved, the bank is permitted to assess the credit risk of its exposures using its internal rating systems, and to employ the risk measurements produced by those ratings systems in the calculation of required regulatory capital. Both wholesale and retail portfolios will employ estimates for probability of default (PD), loss given default (LGD) and exposure at default (EAD) based on internal data. We are diligently working toward adoption of the AIRB approach for all material portfolios, and have submitted to the OSFI a phased AIRB adoption plan that will satisfy that objective. 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 Board of Directors through the Audit Committee approves risk On an industry basis, we believe current model-based measure- limits for controlling funding and liquidity risk. These limits form part of our liquidity management framework as set out by Corporate Treasury. Liquidity risk limits are 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. Any liquidity risk exposures exceeding policy limits must be approved by the Executive Vice-President Corporate Treasury or his delegate, with notice provided to the COO. Reporting GRM provides timely and comprehensive risk reporting to senior man- agement and the Board of Directors on major risks being assumed by or facing the organization, enabling appropriate management and over- sight. This reporting includes, but is not limited to (i) all large exposure exceptions to credit policy, (ii) large counterparty exposures, (iii) signifi- cant counterparty downgrades and (iv) information on capital adequacy. Basel II Basel II is a new international capital adequacy framework that will more closely align regulatory capital requirements with the underlying eco- nomic risks. The official implementation date in Canada is November 1, 2007, following a one-year parallel run with current capital requirements. Basel II represents a major change in bank regulation, in that it allows management to select from a menu of approaches for the calculation of the minimum capital required to support the credit and operational risk undertaken by banks. Credit risk ment methodologies remain unproven as a credible and robust means of calculating capital for the purposes of underpinning operational risk. RBC’s approach brings the benefits of sounder operational risk manage- ment and governance, positioning it 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. We continue to work closely with the OSFI and key host supervisors to ensure that our approach to opera- tional risk management and Basel II compliance is clearly understood and consistent with regulatory expectations. Basel program integration office We established a Basel program integration office in 2004 to direct and manage the enterprise-wide implementation effort, which has the full and active support of senior management. The Basel Program is co-sponsored by the COO and the Chief Information Officer and is governed by a steering committee comprised of senior executives of the functional areas that will be most impacted by the implementation including Group Risk Management, Corporate Treasury and Global Technology and Operations. We have dedicated significant resources and management attention to the Basel II implementation effort, and senior management is satisfied with the bank’s progress towards compliance. Credit risk is the risk of loss associated with a counterparty’s inability to fulfill its payment obligations. We incur credit risk in our business segments through the extension of credit and other transactions with various counterparties, including on- and off-balance sheet items such as loans, acceptances, letters of credit and guarantees. Responsibilities Oversight of credit risk is provided by the Board of Directors through the Conduct Review and Risk Policy Committee (CR&RPC). Credit risk approval authorities are established by the Board of Directors upon recommendation of the CR&RPC, and delegated to senior management. Any transactions exceeding management’s authorities must be approved by the CR&RPC. Group Risk Management (GRM) sets out the enterprise-wide requirements for the identification, assessment, monitoring and report- ing of credit risk. Business segments are accountable for the credit risks within their businesses, working in partnership with GRM on the proper alignment between risk appetite and business strategies. Risk measurement Credit risk is measured on an ongoing basis at the borrower and portfolio levels in order to ensure management is aware of changes in our risk Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 75 profile. Our portfolio is segmented into wholesale, and consumer and small business, and each employs its own risk measurement and assess- ment processes. Wholesale portfolio The key parameters used in measuring and monitoring our exposure to expected loss and calculating credit risk economic capital are the probability of default (PD), loss given default (LGD) and exposure at default (EAD). Using these risk parameters, we can measure and monitor our credit risk to ensure it remains within established limits and our risk tolerance levels. These risk parameters are determined based on historical experi- ence, supplemented by benchmarking and are updated on a regular basis. The estimation of PD, LGD and EAD rates are either established or approved by GRM ensuring independence and consistency. Validation procedures related to these parameters are currently in place and continue to be enhanced in order to meet the requirements of the Basel II Accord. The aim of the validation procedures is to ensure we (i) identify factors that differentiate risk, (ii) produce measures that appropriately quantify risk and (iii) produce measures of risk that respond to changes in the macroeconomic and credit environments. Economic capital Credit risk is the largest contributor to overall economic capital. In addi- tion to the quantification of unexpected loss, Economic capital is used in setting Single Name and Industry limits in order to manage concen- tration in the wholesale portfolio. In the consumer and small business portfolio, Economic capital is used in the risk-based pricing decisions and profitability measurement to ensure an appropriate risk/return balance. 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 consumer and small business portfolios. To this end, sensitivity tests are run using different assumptions to examine the impact on key portfolio metrics. In addition to sensitivity testing, stress tests are used to assess client and portfolio vulnerability to the impacts of unlikely but possible extreme events such as a significant market disruption or a significant downturn in a particular industry. Risk control We manage our credit risk in the organization through policy requirements, established authorities and limits, mitigation activities and reporting. Probability of default Probability of default (PD) measures the probability that a given borrower will default within a 1-year time horizon. In order to determine the PD of any given borrower, the borrower is assigned a Borrower Risk Rating (BRR) using a 22-point scale. The BRR, which is largely consis- tent with external rating agencies, is underpinned by methodologies developed by industry specific experts in GRM. The assessment used to assign a BRR is based on a detailed review of industry sector trends, market competitiveness, overall company strategy, financial strength, access to funds and the financial management of the borrower. Each BRR differentiates the riskiness of the borrower from a default perspective and corresponds to the statistical probability of default by a borrower within the next year. Loss given default Loss given default (LGD) represents the amount expected to be lost when a counterparty or borrower defaults. The level of LGD depends on the type of collateral, the seniority of debt, and the industry in which the counterparty operates. The LGD is based on historical experience, supplemented by benchmarking and is updated on a regular basis. Exposure at default Exposure at default (EAD) represents the expected level of usage of the credit facility when default occurs. At default the borrower may have drawn the loan fully or have repaid some of the principal. The estimate is also based on historical experience, supplemented by benchmarking and is updated on a regular basis. Policies Risk review and approval processes are established by GRM based on the nature, size and complexity of the risk involved. Requirements for the review and monitoring of credit risks are set out in a number of enterprise level policies including: • • • • Delegated risk approval authorities by the Board of Directors Policy on risk limits Enterprise-wide credit risk policies Credit principles, rules and guidelines. Authorities and limits Limits are used to ensure our portfolio is well diversified and within our risk appetite as approved by the Board of Directors. We have notional and economic capital limits for single name and sector exposures. Country exposure is managed by a set of notional limits. Finally, product limits ensure we are not overexposed to any one structure. Credit risk mitigation In addition to limits, credit risk is mitigated through credit structuring, credit derivatives and loan sales. Proper structuring of a credit facility is key in mitigating risk at the transaction level. This includes guarantees, collateral and covenants. We also mitigate risk through credit deriva- tives that serve to transfer the risk to a third party. Procedures are in place to ensure that these hedges are efficient and effective. Decisions on loan sales are made based on an assessment of the market price, our view of the underlying borrower risk as well as the impact on our overall portfolio. Consumer and small business portfolio For Consumer and small business credit portfolios, customized credit scoring models are used for risk measurement. Application scoring models, which are used for underwriting pur- poses, utilize established statistical methods of analyzing new applicant characteristics and past performance to estimate future credit perfor- mance. In model development, all sources of data that are accessible are used and include internal data and external information from credit bureaus. Behavioural scoring is used in the ongoing management of con- sumer and small business accounts. 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. Combined with risk indicators from external sources, this tool has proven to be a leading indicator of risk for our existing accounts, and has identified significant opportuni- ties for improving the risk/return tradeoffs. Reporting Enterprise level credit risk reports are provided by GRM to senior man- agement and the Board of Directors on a quarterly basis to ensure any shifts or negative trends in credit profile are highlighted. For the wholesale portfolio, an analysis is provided to management for monitoring purposes which includes reporting on significant shifts in exposures, expected loss, economic capital, risk ratings and loan clas- sifications. In addition, large exposure credit policy exceptions, large counterparty exposures, and significant counterparty downgrades are reported. Analysis is provided on a portfolio basis and an industry sector basis and includes the results of stress testing and sensitivity analysis. A monthly report for consumer and small business loan portfolios is used to assess and monitor shifts in portfolio quality. Each portfolio is assigned one of the following portfolio quality trend indicators – declining, stable or improving – based on specific performance indica- tors. Other key information in the report includes items such as loss rates and delinquency formations. Royal Bank of Canada Annual Report 2006 76 Management’s Discussion and Analysis Credit portfolio analysis 2006 vs. 2005 During 2006, our credit portfolio remained well diversified and continued to show strong growth. Total loans and acceptances increased $20 billion, or 10%, compared to the prior year. The increase reflected strong growth in both our consumer and our business and government portfolios, driven by strong loan demand against the backdrop of generally favourable North American economic conditions. Our overall credit quality remained solid. Consumer credit quality remained well supported by continuing favourable credit conditions and solid debt-servicing capacity of households. As well, strong corporate earnings and healthy balance sheets continued to support our business credit quality. Loans and acceptances outstanding by credit portfolio and geography (1) Table 47 (C$ millions, except percentage amounts) Residential mortgages Personal Credit cards Consumer Business and government Total loans and acceptances Canada United States Other International Total loans and acceptances Total allowance for loan losses 2006 2005 2006 vs. 2005 Increase (decrease) $ 96,675 44,902 7,155 $ 91,043 41,045 6,200 $ 5,632 3,857 955 $ 148,732 70,315 $ 138,288 60,700 $ 10,444 9,615 $ 219,047 $ 198,988 $ 20,059 $ 188,439 21,499 9,109 $ 173,747 20,058 5,183 $ 14,692 1,441 3,926 $ 219,047 $ 198,988 $ 20,059 (1,409) (1,498) 89 6% 9 15 8% 16 10% 8% 7 76 10% 6 10% Total loans and acceptances, net of allowance for loan losses $ 217,638 $ 197,490 $ 20,148 (1) Geographic information is based on residence of borrower. Consumer loans increased $10 billion, or 8%, from a year ago largely due to domestic growth across all categories. Residential mortgages were up $6 billion, or 6%, despite the offsetting effect of $13.6 billion of net securitization during the year. This growth was supported by a strong housing market, low but rising interest rates, strong labour market conditions, as well as continued consumer confidence. Our sales efforts also contributed to the increase. Personal loans grew $4 billion, or 9%, reflecting continued growth in credit lines in Canada driven by strong consumer spending in a relatively low interest rate environment. Credit cards increased $1 billion, or 15%, despite the offsetting effect of $550 million of net securitization during the year. The increase reflected successful sales efforts and continued consumer spending. Business and government loans and acceptances rose $10 billion, or 16%, largely reflecting solid loan demand due to business spending on inventories, machinery and equipment and the consolidation of our 50% proportionate share in RBC Dexia IS. The increase occurred across all sectors, with the largest increase realized in financial services and real estate-related sectors. Financial services increased $3 billion largely reflecting lending activity related to RBC Dexia IS and higher lending to U.S. financial institutions. Real estate-related exposure was up $2 billion, largely due to lending to Canadian real estate developers reflecting a relatively strong housing market. For further details, refer to Table 58 of the Additional financial information section. Our portfolio remained well diversified and the overall mix did not change significantly from the prior year, with residential mortgages comprising 44%, business and government of 32%, personal loans of 21% and credit cards of 3%. The portfolio grew across all geographic regions, supported by solid global economic conditions. The largest increase was in Canada, with broad-based growth across both our consumer and business and government portfolios. Growth in business lending accounted for most of the increase in the United States and Other International. For further details, refer to Table 59 of the Additional financial information section. Total loans and acceptances by credit portfolio (C$ billions) 250 200 150 100 50 0 Business and government Credit card Personal Residential mortgages 2002 2003 2004 2005 2006 Five-year trend Over the last five years, total loans and acceptances largely trended upward. Compared to 2002, our portfolio increased $43 billion, or 25%, primarily reflecting the increase in our consumer portfolio. Consumer loans grew $40 billion, or 37%, since 2002, largely due to strong growth in Canada across all categories, notwithstanding mortgage and credit card securitizations. This growth was driven by generally favourable economic conditions and increased focus on growing our consumer portfolio. Our business and government portfolio grew $3 billion, or 4%, since 2002. The largest growth sectors were real estate-related, government and automotive. Real estate-related exposure increased $5 billion due to broad-based growth in the United States and Canada, driven by generally favourable economic conditions and relatively solid housing markets in North America over the last three years. Government exposure increased $1 billion due to additional lending to provincial governments in Canada, and municipal governments in the United States driven by the expansion of our U.S. operations. The increase in the automotive sector of $1 billion is mainly due to domestic exposure to dealers, and rental and leasing companies. Our efforts, which largely took place in 2002, to reduce credit exposure to risk-sensitive sectors resulted in decreases in the technology and media, and transportation and environment sectors. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 77 Compared to 2002, our portfolio mix shifted, reflecting our efforts to move towards a lower-risk profile. Consumer loans increased from 62% of total loans and acceptances in 2002 to 68% in 2006, while business and government loans decreased correspondingly over the period. For further details, refer to Tables 58 and 59 of the Additional financial information section. Our portfolio continued to grow in Canada since 2002, reflecting strong loan demand and favourable economic conditions. Our exposure in the U.S. and Other International trended downward except for recent years, partly reflecting our strategic reduction in exposure to risk- sensitive sectors, a reduction in single-name concentrations and our exit of non-core client relationships. With our successful strategic adjust- ment in these areas, our exposure in the U.S. and Other International increased in 2005 and 2006, respectively, largely reflecting organic growth as well as our expansion initiatives. 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 (C$ millions, except percentage amounts) Gross impaired loans, beginning of year Consumer Business and government New impaired loans Consumer Business and government Repayment, return to performing status, sold and other Consumer Business and government Net impaired loan formations Consumer Business and government Write-offs Consumer Business and government Gross impaired loans, end of year Consumer Business and government Total gross impaired loans Key ratios Gross impaired loans as a % of gross loans and acceptances Total net write-offs as a % of average loans and acceptances Allowance for credit losses continuity (C$ millions, except percentage amounts) Specific allowance Balance, beginning of year Provision for credit losses Write-offs Recoveries Adjustments Specific allowance for credit losses, end of year General allowance Balance, beginning of year Provision for credit losses Adjustments General allowance for credit losses, end of year Allowance for credit losses Allowance for credit losses as a % of gross impaired loans n.m. not meaningful Royal Bank of Canada Annual Report 2006 78 Management’s Discussion and Analysis 2006 2005 2006 vs. 2005 Increase (decrease) Table 48 $ $ $ 305 469 774 746 335 335 924 1,259 912 291 $ $ $ 1,081 $ 1,203 $ (124) $ (184) (352) $ (566) (308) $ (918) $ 622 151 773 $ $ 560 (275) $ 285 $ (583) $ (130) (590) $ (180) (713) $ (770) $ 344 490 834 $ $ 305 469 774 $ $ (30) (455) (485) (166) 44 (122) 228 382 610 62 426 488 7 50 57 39 21 60 (9)% (49) (39)% (18)% 15 (10)% 65% 67 66% 11% 155 171% 1% 28 7% 13% 4 8% .38% .25% .39% .32% (1)bps (7)bps n.m. n.m. 2006 2005 2006 vs. 2005 Increase (decrease) Table 49 $ 282 482 (713) 205 7 $ 487 389 (770) 174 2 263 $ 282 $ $ $ $ 1,286 (53) (10) 1,223 1,486 178% $ $ $ 1,227 66 (7) 1,286 1,568 203% (205) 93 57 31 5 (19) 59 (119) (3) (63) (82) n.m. (42)% 24 7 18 250 (7)% 5% (180) (43) (5)% (5)% n.m. $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 2006 vs. 2005 Gross impaired loans Gross impaired loans increased $60 million, or 8%, compared to the prior year, largely reflecting loan growth. Both our consumer and busi- ness and government portfolios recorded higher impairment this year. Consumer gross impaired loans increased $39 million, or 13%, from a year ago, with increases in both residential mortgages and personal loans. Gross impaired residential mortgages increased $18 million, or 13%, which was primarily due to portfolio growth and higher impairment in domestic residential mortgages. The increase in impairment in personal loans was largely related to domestic credit line products in part reflecting the overall portfolio growth. Business and government gross impaired loans increased $21 million, or 4%, compared to the prior year. While the increase was across a number of sectors, the small business and government sectors recorded the largest increases in impairment. The increase was partially offset by a reduction in impairment in the energy sector primarily resulting from the favourable resolution of a previously impaired U.S. borrower. Gross impaired loans as a percentage of loans and acceptances remained relatively stable at .38%, compared to .39% in the prior year, as the increase in gross impaired loans was commensurate with the growth in the overall portfolio. For further details, refer to Table 60 of the Additional financial information section. Allowance for credit losses Total allowance for credit losses decreased $82 million, or 5%, from a year ago. The decrease was largely due to a $50 million reversal of the general allowance in 2006 reflecting the strengthening credit quality of our corporate loan portfolio, and a reduction in the specific allowance for both our consumer and business and government portfolios. The specific allowance decreased $19 million, or 7%, from the prior year. The reduction was mainly in our domestic personal loan and U.S. corporate portfolios. The general allowance decreased $63 million, or 5%, compared to the prior year, largely reflecting a $50 million reversal of general allowance in light of the strengthening credit quality of the corporate loan portfolio reflecting continuing favourable credit conditions. Total allowance for credit losses as a percentage of gross impaired loans decreased to 178% compared to 203% a year ago, primarily reflecting the reduction in the general allowance. For further details, refer to Table 62 of the Additional financial information section. Gross impaired loans (GIL) and allowance for credit losses (ACL) (C$ millions) 2,400 1,800 1,200 600 0 1.20% .90% Gross impaired loans ACL .60% GIL ratio* .30% .0% 2002 2003 2004 2005 2006 * GIL ratio: GIL as a percentage of total gross loans and acceptances. Five-year trend Gross impaired loans Over the past five years, gross impaired loans largely trended down- ward, decreasing $1,454 million, or 64%, from 2002, primarily due to lower impairment in our corporate loan portfolio. The reduction was largely attributable to the favourable resolution of a number of previ- ously impaired corporate loans that arose in 2001 and 2002. In 2006, consumer gross impaired loans decreased $93 million, or 21%, compared to 2002, largely due to lower impairment in personal loans in Canada and the U.S. In 2006, business and government gross impaired loans declined $1,361 million, or 74%, compared to 2002. The decline was across all geographic regions and most industry sectors, with the largest decrease in the energy, forest products, transportation and environment, and technology and media sectors. The decrease reflected our proactive management of problem accounts and improvement in credit conditions over the period. The ratio of gross impaired loans as a percentage of loans and acceptances declined significantly to .38% in 2006, compared to 1.30% in 2002, reflecting the factors above. Allowance for credit losses Over the past five years, total allowance for credit losses of $1,486 million in 2006, decreased $828 million, or 36%, from 2002. The decrease was largely due to a reduction in specific allowance, reflecting lower corporate impairment due to improved credit conditions. The specific allowance of $263 million in 2006 was down $631 million, or 71%, compared to 2002. The decrease was broad- based across all portfolios, industry sectors and geographic regions. The business and government portfolio recorded the largest reduction in specific allowance, in line with the significant decline of impairment over the period. The general allowance of $1,223 million in 2006, decreased $197 million, or 14%, compared to 2002. The decrease was due to a $175 million reversal of the general allowance in 2004, and a $50 million reversal of the general allowance in 2006, largely reflecting improved credit quality and economic conditions. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 79 Provision for credit losses The provision for credit losses is charged to income by an amount necessary to bring the allowance for credit losses to a level determined appropriate by management, as discussed in the Critical accounting policies and estimates section and Note 1 to our Consolidated Financial Statements. Provision for credit losses by credit portfolio and geography (1) (C$ millions, except percentage amounts) Residential mortgages Personal Credit cards Consumer Business and government Total specific provision for loan losses Canada United States Other International Total specific provision for loan losses Total general provision Total provision for credit losses Specific provision as a % of average loans and acceptances Geographic information is based on residence of borrower. (1) n.m. not meaningful 2006 vs. 2005 Total provision for credit losses decreased $26 million, or 6%, from a year ago largely reflecting the continued strong credit quality of our portfolio and favourable credit conditions. The specific provision as a percentage of average loans and acceptances in 2006 was .23% compared to .21% in 2005, largely reflecting an increase in specific provisions over the prior year. Specific provision for credit losses for consumer loans was up $20 million, or 4%, compared to the prior year. The increase was largely due to higher provisions in Canadian personal loans in part reflecting portfolio growth, which was partly offset by the favourable impact of the higher level of securitized credit cards. Table 50 2006 vs. 2005 Increase (decrease) $ $ $ $ $ $ $ 2006 2005 $ $ $ $ 6 306 163 475 7 482 507 (26) 1 2 $ 259 194 455 (66) $ 389 $ $ 435 (45) (1) 482 $ 389 $ 4 47 (31) 20 73 93 72 19 2 93 (53) $ 429 $ .23% $ $ 66 455 .21% (119) (26) 2 bps 200% 18 (16) 4% 111 24% 17% 42 200 24% (180)% (6)% n.m. Specific provision for credit losses (C$ millions) 1,200 900 600 300 0 2002 2003 2004 2005 2006 Specific PCL PCL ratio* .60% .45% .30% .15% .0% Business and government provision for credit losses increased * PCL ratio: Specific PCL as a percentage of average loans and acceptances. $73 million over the prior year. The increase primarily reflected the transfer of $52 million from the specific allowance to the general allowance in the prior year as a result of the alignment of our enterprise- wide accounting treatment of credit losses, lower recoveries in our corporate and agriculture portfolios, and higher provisions in small business loans. These factors were partially offset by a lower provision in our U.S. business portfolio reflecting continued strong credit quality. The prior year included a provision related to our 50% proportionate share of a provision booked at Moneris. The general provision decreased $119 million from a year ago. The decrease was largely due to a $50 million reversal of the general allowance this year in light of the strengthening of our corporate loan portfolio reflecting continuing favourable credit conditions and the transfer of $52 million from the specific allowance to the general allowance in the prior year. Five-year trend Over the last five years, specific provision for credit losses decreased significantly, despite a 25% increase in total loans and acceptances. The decrease was largely due to a reduction in provisions for our corporate loan portfolio, which recorded a high level of provision in 2002 and significant recoveries in 2005 and 2006. These factors were partially offset by an increase in consumer specific provisions in the last couple of years, primarily driven by significant portfolio growth of credit card and personal loans. The specific provision as a percentage of average loans and acceptances declined to .23% in 2006, compared to .62% in 2002, largely reflecting the significant reduction in provisions related to corporate loans over the period. For further details, refer to Table 61 of the Additional financial information section. Royal Bank of Canada Annual Report 2006 80 Management’s Discussion and Analysis Market risk Market risk is the risk of loss that results from changes in interest and foreign exchange rates, equity and 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 com- posed of (i) repricing risk – arising from differences in the maturity of timing of repricing of the assets, liabilities and off-balance sheet instruments, (ii) directional risk – arising from parallel shifts in the yield curve, (iii) yield curve risk – arising from non-uniform rate changes across a spectrum of maturities, (iv) basis risk – resulting from an imperfect hedge of one instrument type by another instru- ment type whose changes in price are not perfectly correlated, and (v) option risks – arising from changes in the value of embedded options due to changes in interest 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 posi- tions, 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 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. Credit spread risk is the potential adverse impact on our earnings and economic value due to changes in the credit spreads associ- ated with our holdings of credit-risky instruments. • • • • • 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 and 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 – Market and Trading Credit Risk, which includes major units in Toronto, London, New York and Sydney. The Market and Trading Credit Risk group estab- lishes 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 the market risks within their businesses, 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 deter- mination 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 statisti- cal 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. 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 inter- val, a portfolio with a VAR of $15 million held over one day would have a one in one hundred chance of suffering a loss greater than $15 million in that day. VAR is measured over a 10-day horizon for the purpose of deter- mining 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. Furthermore, the use of a 10-day VAR for risk measurement implies that positions could be unwound or hedged within 10 days. 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 com- pare hypothetical profit or loss against the VAR to monitor the statistical validity of 99% confidence level of the daily VAR measure. Back-testing is calculated by holding position levels constant and isolating the effect of actual market rates movements over the next day 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 on a periodic basis to further ensure accuracy and reliability. In 2006, there were no occurrences of a back-test exceeding VAR. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 81 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 con- ditions. 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. 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 RBC 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 RBC Capital Markets. The following table shows our global VAR for total trading activities by major risk category and the diversification effect. During the year, we included our credit default swap business in the interest rate and credit specific VAR using the models approach to VAR measurement. Global VAR by major risk category Table 51 (C$ millions) Equity Foreign exchange Commodities (1) Interest rate Credit specific Diversification Global VAR 2006 2005 As at Oct. 31 year-end For the year ended October 31 High Average Low As at Oct. 31 year-end For the year ended October 31 High Average Low $ 7 2 1 13 3 (9) $ 17 $ 11 4 2 20 4 n.m. $ 25 $ 7 2 1 13 3 (8) $ 18 $ 5 1 – 9 2 n.m. $ 13 $ 7 1 1 12 2 (8) $ 15 $ 10 5 2 16 3 n.m. $ 17 $ 6 2 1 10 2 (9) $ 12 $ 4 1 – 6 1 n.m. 8 $ (1) Commodities reflect market risk for energy-related trading activities such as crude, heating oil and natural gas. Effective May 2005, these activities have been included in our models and reported alongside other Market risk trading activities. Prior to May 2006 these activities had been subject to the standardized approach for capital allocation. n.m. not meaningful Global VAR by major risk category (C$ millions) 0 -3 -6 -9 -12 -15 -18 -21 November 2004 May 2005 November 2005 May 2006 October 2006 Daily interest rate VAR Daily equity VAR Daily commodities VAR Daily credit specific risk VAR Daily foreign exchange VAR Global VAR 2006 vs. 2005 Average global VAR for the year of $18 million was up compared to $12 million a year ago largely due to an increase in interest rate global VAR. This increase in VAR for interest rates is due to increased trading activity and an increase in correlation between the interest rate busi- nesses in the current year. Overall diversification benefit, which is calculated as the difference between the global VAR and the sum of the separate risk factor VARs, was reduced to 31% compared to 43% a year ago. Trading revenue 2006 vs. 2005 During the year, we experienced six days of net trading losses. The largest loss of $4.87 million did not exceed the Global VAR estimates for that day. The breadth of our trading activities is designed to diversify market risk to any particular strategy, and to reduce trading revenue volatility. The low volatility and the consistent growth of our trading revenue is a reflection of our broad product and geographic diversity. Royal Bank of Canada Annual Report 2006 82 Management’s Discussion and Analysis Histogram of daily net trading revenue (1) (number of days) Daily net trading revenue and global VAR (1) (C$ millions) Histogram of daily net trading revenue (1) (number of days) Daily net trading revenue and global VAR (1) (C$ millions) 18 12 6 0 60 50 40 30 20 10 0 -10 -20 -30 18 12 6 0 60 50 40 30 20 10 0 -10 -20 -30 -5 0 10 20 30 40 50 60 Daily net trading revenue (C$ millions) November 2005 February 2006 May 2006 August 2006 October 2006 -5 0 10 20 30 40 50 60 Daily net trading revenue (C$ millions) November 2005 February 2006 May 2006 August 2006 October 2006 Daily net trading revenue Global VAR Daily net trading revenue Global VAR (1) Trading revenue on a taxable equivalent basis excluding revenue related to consolidated VIEs. Non-trading market risk (asset and 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. We continually monitor the effectiveness of our interest rate risk mitigation activity within Corporate Treasury on a value and earnings basis. 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 Liability Committee (ALCO) provides oversight to Corporate Treasury. ALCO 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 client rates 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. 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 simu- late 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 an immediate and sustained ± 200 basis point parallel shift of the yield curve. The limit for net interest income risk is 6% of projected net interest income and the limit for economic value of equity risk is 12% of projected common equity. Interest rate risk policies and limits are reviewed annually. 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 prin- ciples. They are supported by empirical research into client behaviour and are an integral input to the retail business pricing decisions. Risk reporting The individual subsidiaries and business segments report the interest rate risk management activity on a monthly basis. They must also imme- diately report any exceptions to the established policy to Corporate Treasury and seek approval of the corrective actions. An enterprise interest rate risk report is reviewed monthly by ALCO and quarterly by the Group Risk Committee and by the Board of Directors. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 83 Market risk measures – Non-trading banking activities Table 52 (C$ millions) 2006 2005 2004 Economic value of equity risk Net interest income risk Economic value of equity risk Net interest income risk Economic value of equity risk Net interest income risk Before-tax impact of: 100bp increase in rates 100bp decrease in rates Before-tax impact of: 200bp increase in rates 200bp decrease in rates $ (496) $ 375 (1,044) 658 $ 87 (153) 147 (319) (435) $ 291 (920) 461 $ 106 (181) 162 (365) (412) $ 215 (882) 405 70 (150) 107 (314) 2006 Analysis The above table provides the potential before-tax impact of an imme- diate 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 2006, 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 lead to failure in the management of other risks such as credit risk, market risk or regulatory risk. Our operational risk management framework sets out a common language for operational risk and the principles and practices by which we manage operational risk, including risk identification, measurement, mitigation and monitoring. Under this framework, we consider operational risk from three perspectives: causes, events and impacts. Detailed categories and definitions for each of these are included in the framework to support the consistent identification and assessment of risks. Responsibilities As with all significant risks, the Board of Directors is responsible for providing management oversight and ensuring that appropriate policies have been implemented to manage operational risk. The Chief Risk Officer and Group Risk Management are responsible for develop- ing and implementing the operational risk management framework on an enterprise-wide basis, as well as for directing and approving significant business-specific operational risk policies. Within Group Risk Management, a dedicated team has been established to design and support operational risk policies, programs and initiatives and to monitor implementation progress and ongoing execution. The Business Segments are responsible for managing operational risk within their operations in accordance with the operational risk manage- ment framework. Where appropriate, execution of certain operational risk management programs is conducted by Global Technology and Operations on behalf of the businesses. Risk measurement Since exposure to operational risk is often implicit or not taken on intentionally, complete and precise measurement is difficult. Current measurement methodologies and tools continue to evolve in the indus- try. Nonetheless, we use several approaches concurrently to gauge our operational risk exposure. Risk assessment During 2006, assessments of operational risks were carried out through enterprise-wide programs that evaluated individual key risks such as financial reporting risk (Sarbanes-Oxley Act of 2002), privacy, out- sourcing, fraud and money laundering. To improve efficiency and effectiveness, several of these programs were brought together into a single, integrated operational risk and con- trol assessment program launched November 1, 2006. The integrated Royal Bank of Canada Annual Report 2006 84 Management’s Discussion and Analysis program provides consistent identification and assessment of opera- tional risks and the controls used to manage these risks. Risk indicators A broad range of risk indicators are used by the Business Segments to manage their day-to-day operations and by Group Risk Management to monitor operational risk at the enterprise level. These indicators pro- vide insight into potential changes in our operational risk exposure and assist with proactive management of this risk. Loss event data collection and analysis We have established comprehensive standards requiring that opera- tional risk events be identified and reported in the enterprise Loss Event Database when they occur. Required information includes the amount of the loss, any recoveries, relevant dates, root causes and risk drivers affecting the loss. Collection of internal operational loss data helps us to understand where and how our risks are manifesting themselves, provides a historical perspective of our operational loss experience, and establishes a basis for measuring our operational risk exposure and the capital needed to underpin this. Industry loss analysis We review and analyze published information on operational losses that have occurred at other financial institutions. This provides insight into the size and nature of potential exposures, and allows us to monitor emerging developments or trends that affect the financial industry as a whole. Risk control Complementing our infrastructure, controls, systems and people are our activities under the operational risk management framework and those of several central enterprise-wide groups which focus on aspects such as control effectiveness, management of specific operational risks, and transfer of risk. These groups include (i) fraud management, which focuses on prevention, detection and intervention regarding both internal and external fraud; (ii) the compliance group, which ensures a complete view of our regulatory demands and provides a co-ordinated, effective response to these; (iii) the business continuity management group, which co-ordinates planning, preparation and response for business disruption and crisis situations which may affect our ability to provide quality and timely services to our clients; (iv) the corporate insurance group, through which we 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; and (v) the internal audit group, which provides independent assessment of risk management practices, internal controls and corporate governance processes. Risk mitigation Our corporate insurance program quantifies our appetite for particular segments of operational risk and works with businesses and functional partners to strategically manage the related risks. Liquidity and funding risk Liquidity and funding risk is the risk that an institution is unable to generate 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 reliable and cost-effective sources of cash or its equivalents are available to satisfy our current and prospective financial commit- ments 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 • 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 rein- force these risk mitigation strategies by assigning prudential limits or targets to metrics associated with these activities and regularly measur- ing and monitoring various sources of liquidity risk under both normal and stressed market conditions. 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 manage- ment framework, pledging framework and liquidity contingency plan, and the Board of Directors is informed on a periodic basis about our current and prospective liquidity condition. The GRC and the Asset and Liability Committee 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 con- tingency plans and for recommending and monitoring limits within the framework. In this role, Corporate Treasury is assisted by GRM. 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 estimates and judgments pertaining to current and prospective firm-specific and market conditions and the related behaviour of our clients and counter- parties. We measure and manage our liquidity position from three risk perspectives as follows: Reporting Group Risk Management provides quarterly enterprise level reporting to senior management and the Board of Directors which includes an overview of our operational risk profile. Details are provided on large operational events, areas of heightened risk, insurance coverage, potential emerging risks, fraud management activities, status of busi- ness continuity preparedness, and regulatory or compliance issues. This reporting is supplemented with more detailed specific reporting by groups such as compliance, audit and legal. Structural liquidity risk Structural liquidity risk management addresses the risk due to mis- matches 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 the cash capital methodology to assist in the evaluation of balance sheet liquidity and determination of the appropriate term structure of our debt financing. It also allows us to measure and monitor the relationship between illiquid assets and core funding, including our exposure to a protracted loss of unsecured wholesale deposits. 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, which are subject to an enterprise-wide framework that assigns risk-adjusted limits to all transaction types. Pledged assets include a pool of eligible assets that are reserved exclusively to support our participation in Canadian payment and settlement systems. Contingent liquidity risk Contingent liquidity risk management addresses the risk of and our intended responses to general market disruptions, adverse political/ economic developments and a series of progressively more severe RBC credit rating downgrades. The liquidity contingency plan identifies comprehensive action plans that would be implemented depending on the duration and severity of the variety of stressful events listed above. Corporate Treasury maintains and administers the liquidity contingency plan. The Liquidity Crisis Team meets regularly to engage in stress and scenario test exercises and to modify the liquidity contingency plan in light of lessons learned. 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 (e.g., 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 portfolios are subject to minimum asset levels and strict eligibility guidelines to ensure ready access to cash in emergencies. Risk control We manage our liquidity position on a consolidated basis and consider legal, regulatory, tax, operational and any other restrictions when analyzing our ability to lend or borrow funds between our legal entities. Policies Our principal liquidity and funding policies are reviewed and approved annually by the senior management committees and the Board of Directors. These broad policies authorize senior management commit- tees or Corporate Treasury to approve more detailed policies and limits Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 85 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. 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 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. 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 conse- quences for our funding capacity, collateral requirements and on the results of our operations. Credit ratings As at November 29, 2006 Short-term Senior debt long-term debt Moody’s Investor Services Standard & Poor’s Fitch Ratings Dominion Bond Rating Service P-1 A-1+ F1+ R-1(high) Aa2 AA- AA AA Table 53 Outlook stable stable stable stable Our strong credit ratings support our ability to competitively access unsecured funding markets. At the end of 2006, all our ratings have returned to stable outlook upon the resolution of Standard & Poor’s negative outlook earlier this year with no rating implications. Near the end of the year, Dominion Bond Rating Service implemented a meth- odology change applicable to banks which led to a one-notch increase of our ratings and those of our peers. As a result, our short-term debt rating was increased to R-1(high) from R-1(middle) and our senior long- term debt rating was increased from AA(low) to AA. Royal Bank of Canada Annual Report 2006 86 Management’s Discussion and Analysis All of our ratings are amongst the highest categories assigned by the respective agencies to a Canadian bank (our current ratings are at par with, or at a one-notch premium to, our major Canadian banking peers). In 2006, we were once again named as the safest Canadian bank and the 4th safest North American bank by Global Finance magazine. 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. Deposit profile The composition of our global deposit liabilities is summarized in Note 13 to our Consolidated Financial Statements. In 2006, personal deposits remained the prime source of funding for our Canadian dollar balance sheet while most foreign currency deposits originated from unsecured, wholesale sources, including large corporate and institu- tional 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 prospective 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. As at October 31, 2006, our core deposits, which include our statistical estimates of the stable portions of our personal and commercial/institutional transactional balances, expected renewal rates for personal fixed term deposits under one year and personal and wholesale funds maturing beyond one year, represented about 54% of our total deposits. Year-over-year, this ratio declined about 1% due to growth in short-term, unsecured deposits used to fund liquid assets. 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 54 (C$ millions) 2006 2005 2004 Long-term funding outstanding $ 33,361 $ 24,004 $ 18,831 Total mortgage-backed securities sold Commercial mortgage-backed securities sold Credit card receivables financed through notes issued by a securitization special purpose entity 12,186 8,487 1,914 2,500 1,237 2,250 1,900 5,983 603 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. and Europe. Diversification into new markets and untapped investor segments is also constantly evaluated against relative issuance costs. During 2006, we continued to expand our long-term funding base by issuing, either directly or through our subsidiaries, $18.5 billion of senior deposit notes in various currencies and markets. Total long-term funding outstanding increased $9.4 billion. Outstanding senior debt containing ratings triggers, which would accelerate repayment, consti- tutes 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 $3.7 billion. Our credit card receivables, which are financed through notes issued by a securitization special purposes entity, decreased year over year by $250 million. For further details, refer to the Off-balance sheet section and Note 5 to our Consolidated Financial Statements. Our liquidity and funding position remains sound and adequate to execute our strategy. There are no known trends, demands, com- mitments, events or uncertainties that are presently viewed as likely to materially change this position. Contractual obligations In the normal course of business, we enter into contracts that give rise to commitments of future minimum payments that affect our liquidity. Depending on the nature of these commitments, the obligation may be recorded on- or off-balance sheet. The table below provides a summary of our future contractual funding commitments. Contractual obligations (C$ millions) (1) Within 1 year 1 to 3 years 3 to 5 years Over 5 years Total 2006 Table 55 2005 Total 2004 Total Unsecured long-term funding Subordinated debentures Obligations under leases (2) (1) (2) Amounts represent principal only and exclude accrued interest. Substantially all of our lease commitments are operating. Reputation risk $ 9,545 – 419 $ 11,177 140 704 $ 9,471 – 495 $ 3,168 6,963 868 $ 33,361 7,103 2,486 $ 24,004 8,167 2,508 $ 18,831 8,116 2,418 $ 9,964 $ 12,021 $ 9,966 $ 10,999 $ 42,950 $ 34,679 $ 29,365 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 the organization. Failure to effectively manage reputation risk can result in reduced market capital- ization, loss of client loyalty and the inability to expand. The following principles 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. No transaction or action is worth jeopardizing our reputation. • • 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, USA Corporate Governance Committee and Structured Transactions Oversight Committee. Risk control Policies Policies and procedures support the management of reputation risk both directly and indirectly across the organization. Business segments have specific policies in place to manage the risks within their business, including reputation risk. This includes requirements to identify and mitigate reputation risk when considering new business initiatives, products and services. A comprehensive set of policy requirements apply to the identification and assessment of reputation risks, 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 mandatory requirements for managing conflicts of interest. Reporting The responsibility for monitoring and reporting on reputation risk issues is primarily within Group Risk Management. Regular comprehen- sive reporting relevant to the management of reputation risk 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. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 87 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 adhere to or comply with regulations, law, industry codes or rules, regulatory expectations or ethical standards. GRM Compliance has developed a comprehensive enterprise compliance management (ECM) framework that is consistent with regulatory guidance from the OSFI and other regulators. The framework is risk-based and designed to promote the proactive management of regulatory risk. It applies to all of our businesses and operations, legal entities and employees globally and outlines our accountabilities in order to ensure we maintain robust and effective programs for manag- ing regulatory risk. The framework covers nine elements of compliance management: liaison with regulators, risk assessment, control design and oversight, training and education, compliance execution, monitor- ing, issue tracking, reporting, and new initiative management. Responsibilities Group Risk Management (GRM) sets out the enterprise-wide require- ments for the identification, assessment, control, monitoring and reporting of regulatory and legal risk across RBC. Oversight is provided by the Board of Directors through the Conduct Review and Risk Policy Committee (CR&RPC). The Ethics and Compliance Committee supports our management of regulatory risk. It informs and advises GRC and the CR&RPC on significant regulatory issues and remedial measures. GRM Compliance is directly responsible for supporting the man- agement of regulatory and legal risk. It reports to management and the Board of Directors on the overall status of compliance performance and ensures appropriate action plans are executed on a timely basis. The management of regulatory and legal risks is ultimately the responsibility of senior management and the businesses. The Chief Compliance Officer and GRM Compliance work closely with business partners to ensure the overall effectiveness of compliance across the enterprise through the enterprise compliance management program (ECMP), which includes compliance strategy and policies for consistent and effective compliance, independent oversight of compli- ance controls, timely reporting of trends and escalation of issues to senior management and the board. 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 con- trols 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 have begun to use such metrics to iden- tify issues and trends and to track changes in regulatory risk between businesses and over time. 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, from the CEO down, must reconfirm their understanding of and commitment to comply with the code at least every two years, and employees in high-risk roles must do so annually. We administer enterprise-wide delivery of online Code of Conduct training, testing and monitoring through our training technol- ogy, eCampus. We also provide training in compliance and regulatory risk related matters for relevant employees through other online tools (for example, in the area of anti-money laundering compliance), 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 Chief Compliance Officer and GRM Compliance report compliance matters to senior management, management committees and the Board of Directors and its operating subsidiaries. In addition, the Chief Compliance Officer provides an annual report on overall compliance, and on specific topics, such as related party transactions, conflicts of interest, compliance with Canadian consumer protection requirements and anti-money laundering compliance. Similarly, senior compliance officers of our operating subsidiaries pro- vide relevant annual and quarterly reports to their senior management and Board of Directors. Royal Bank of Canada Annual Report 2006 88 Management’s Discussion and Analysis Environmental risk Environmental risk is the risk of loss to financial, operational or reputa- tion value resulting from the impact of environmental issues. These impacts may be direct, such as financial loss sustained from credit pro- vided to owners of contaminated properties, or indirect, such as damage to our reputation resulting from the activities of our clients. We undertake independent and collaborative research, engage stakeholders, measure performance, and carry out benchmarking in order to identify and address the material environmental issues we face. Issues include climate change, sustainable forestry, biodiversity and the rights of indigenous peoples. In relation to climate change, for example, we undertook a high- level carbon risk profile of our lending portfolio in order to assess potential credit risk impacts. While the aggregated carbon risk exposure of our portfolio was not considered significant, we continue to monitor this risk as scientific and economic analysis, regulatory actions and our own portfolios evolve. Responsibilities Our environmental risk activities are managed by the Environmental Risk Management Group (ERMG) and its partners in the businesses and corporate support groups. Oversight of all risks is provided by the Chief Risk Officer and ultimately by the Conduct Review and Risk Policy Committee of our Board of Directors. Operational activities relating to the environment are managed co-operatively by the ERMG, Corporate Real Estate, Strategic Sourcing and Corporate Communications. These groups have expertise in credit, emerging environmental issues, operations and reporting. Collectively, they develop, integrate and manage environmental policy, programs and practices. Risk measurement Some environmental risks associated with our business and operational activities can be easily quantified. These include the costs of rectifying environmental contamination of properties used as security for loans. Other risks are newer, more complex and more difficult to quantify, requiring expert judgment on an ongoing basis to identify environmental issues and estimate impacts. As risk measurement methodologies mature (relative to carbon risk), we will incorporate those considered useful into our processes. Risk control Our Corporate Environmental Policy supplements the environment sec- tion of our Code of Conduct. The policy’s primary focus is to guide our lending practices and operational activities. It is currently under review, and a revised and updated policy addressing emerging environmental issues will be released in 2007. Our environmental credit risk management policies provide a means to proactively identify and manage environmental risks in our lending activities. These policies are regularly reviewed to ensure com- pliance with our legal and operational commitments, and to take into account evolving business activities. Our commitment to the Equator Principles is an integral part of our environmental risk management approach. The Equator Principles are a voluntary set of guidelines that help financial institutions address the environmental and social risks associated with project finance. We have developed an internal policy governing project finance activities in line with these principles. The ERMG continues to communicate with business segments to ensure that existing and emerging environmental risks are appropriately managed and controlled. Enhancements, including further policy development and transaction screening tools, are under consideration. Reporting The Board of Directors and senior management committees are pro- vided with reports and analysis on environmental issues (for example, climate change and the Kyoto Accord, and the Equator Principles), as appropriate. Our annual Corporate Responsibility Report (CRR) provides information to our stakeholders about our areas of focus and progress, including environmental policy, lending, emerging issues, stakeholder engagement, and environmental performance and initiatives. Insurance risk Insurance risk is the risk of loss that may occur when actuarial assump- tions made in insurance product design and pricing activities differ from actual experience. 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 mis-estimation of expected claims activities as compared to actual claims activities, or (ii) the mis- selection 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 administer- ing policies, or of processing claims, exceeds the costs assumed in pricing calculations. • • Insurance risk arises from our life and health, home and auto, travel insurance and reinsurance businesses. We have established an insurance risk management framework which comprises five primary risk management activities: risk oversight and monitoring, risk reviews and approvals, risk event escalation, risk policies and risk reporting. Responsibilities Group Risk Management – Insurance monitors insurance risk via the insurance risk management framework. The collaborative process between risk management and business segments facilitates the identification and prioritization of risks and ensures the appropriate risk mitigants are implemented in order to align with the organization’s risk appetite. Group Risk Management participation in key business activities and processes and in risk-based reviews enables the monitoring of business activities and risks, and the establishment of limits such as underwriting limits. Additional oversight is achieved through periodic compliance assessments, internal audits and other review mechanisms. Risk measurement Insurance risks are measured using in-house models (developed by our Corporate Actuarial Group) and industry models, each of which com- plies with GRM Model Risk Policy. These risk measurements are used for economic capital attribution, for valuation of liability reserves, and for ensuring that our regulatory capital meets the OSFI guidelines for insurance companies. The models are also used for asset-liability man- agement (ALM) purposes. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 89 Our allocation of insurance risk is measured by economic capital. We have a diversified portfolio of insurance risks with the largest single category being less than 30% of our allocated economic capital. Risk mitigation Reinsurance (as a risk mitigation technique) is used for reducing our exposure to insurance risks that may not fit within our desired risk profile. Risk control Policies Risk policies articulate our strategies for identifying, prioritizing and managing risk. Policies communicate a consistent message about risk tolerance and ensure accountability through clear roles and responsibili- ties. Enterprise-wide policies on insurance risk are centrally managed within Group Risk Management. Risk review and approval Product design and pricing risk arising from product initiatives is moni- tored through a structured risk analysis and approval process. Initiatives are reviewed and assigned a risk rating to identify the appropriate level of approval authority within the organization. Additional risks that may affect future results By their very nature, forward-looking statements, including those made in this document, involve numerous factors and assumptions, and are subject to inherent risks and uncertainties, both general and specific, which may cause our future results to differ materially from our expectations expressed in our forward-looking statements. Factors that might cause future financial performance to vary from that described in those forward-looking statements include credit, market, operational and other risks identified and discussed in detail in the Risk manage- ment section. In addition, the following discussion sets forth other factors we believe could cause future results to differ materially from expected results. Industry factors General business and economic conditions in Canada, the U.S. and other countries in which we conduct business Interest rates, foreign exchange rates, 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 spe- cific 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 addi- tion, our provision for credit losses would likely increase, resulting in lower earnings. Similarly, a downturn in a particular equity or debt mar- ket could cause a reduction in new issue and investor trading activity, assets under management and assets under administration, resulting in lower fee, commission and other revenue. 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 on account of 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 three years has had a significant effect on our results. We are also exposed to the British pound on account of our level of operations in the U.K. and activity conducted internationally in this currency. Further appreciation of the Canadian dollar relative to the U.S. dollar or British pound would reduce the translated value of U.S. dollar- and GBP-denominated revenue, expenses and earnings, respectively. Royal Bank of Canada Annual Report 2006 90 Management’s Discussion and Analysis Reporting Group Risk Management – Insurance evaluates and reports on insurance risk related items to management at the business unit level and at the enterprise level on a regular basis. The reports facilitate the analysis and communication of information and contribute to the overall understanding of insurance risk. Reporting includes an assessment of risks facing the various businesses and covers trends related to claims and loss ratios. The reports also enable an assessment of the risk/return profile of insurance products and impart a view of potential risks on the horizon. Government monetary and other policies Our businesses and earnings are affected by the monetary policies that are adopted by the Bank of Canada, 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 U.S. and internationally, which may increase the risk of default by such clients and counterparties. Our businesses and earnings are also affected by the fiscal or other policies that are adopted by various regulatory authorities in Canada, the U.S. and international agencies. 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 disintermediation could also reduce fee revenue and adversely affect our earnings. Changes in laws and regulations Regulations are in place to protect the financial and other interests of our clients, investors and the public interest. Changes to laws, regula- tions or regulatory policies (including tax laws) and 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 The accounting policies we utilize determine how we report our 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 rep- resentations 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 influ- ence 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 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 employ- ees of acquired companies and joint ventures, and there is no assurance that we will always succeed in doing so. Changes in accounting standards and 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. financial condition and results of operations, and they require manage- ment to make estimates or rely on assumptions about matters that are inherently uncertain. Such estimates and assumptions may require revision, and changes to them may materially adversely affect our results of operations and financial condition. Significant accounting policies and estimates are described in Note 1 to our Consolidated Financial Statements. As detailed in the Accounting and control matters 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. Other factors Other factors that may affect future results include changes in government trade policy, the timely and successful development of new products and services, technological changes, 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 transporta- tion, 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. We caution that the foregoing discussion of risk factors that may affect future results is not exhaustive. When relying on our forward- looking statements to make decisions with respect to us, investors and others should carefully consider the foregoing factors, other uncertain- ties 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. 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. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 91 Additional financial information Net interest income on average assets and liabilities from continuing operations (1) Table 56 (C$ millions, except percentage amounts) 2006 2005 2004 2006 Average balances (2) Interest (3) 2005 2004 2006 Average rate 2005 Assets Deposits with other banks Canada United States Other International Securities Trading account Investments Loan substitute 915 $ 629 $ 41 $ $ 1,218 $ 1,856 4,913 7,987 1,587 4,068 6,570 134,166 38,127 665 110,356 37,198 678 1,093 3,897 5,619 94,178 43,146 358 172,958 148,232 137,682 155 284 480 5,056 1,068 31 6,155 31 $ 55 145 8 7 88 3.37% 8.35 5.78 231 103 6.01 3,711 839 33 4,583 2,718 837 17 3,572 3.77 2.80 4.66 3.56 3.39% 3.47 3.56 3.52 3.36 2.26 4.87 3.09 2004 1.27% .64 2.26 1.83 2.89 1.94 4.75 2.59 Assets purchased under reverse repurchase agreements and securities borrowed Loans (4) Canada Residential mortgages Personal Credit cards Business and government United States Other International Total interest-earning assets Non-interest-bearing deposits with other banks Customers’ liability under acceptances Other assets 55,615 44,420 43,920 2,827 1,354 656 5.08 3.05 1.49 90,624 36,840 6,233 33,694 82,960 32,864 6,238 30,026 75,722 28,857 5,656 27,616 167,391 21,871 8,286 152,088 20,572 6,993 137,851 21,329 6,586 197,548 179,653 165,766 434,108 2,806 8,748 56,438 378,875 2,567 6,411 57,447 352,987 2,758 6,047 56,408 4,539 2,701 761 1,420 9,421 2,110 1,177 12,708 22,170 – – – 4,090 2,055 753 1,401 8,299 1,626 865 10,790 16,958 – – – 3,903 1,813 674 1,342 7,732 1,134 669 9,535 13,866 – – – 5.01 7.33 12.21 4.21 5.63 9.65 14.20 6.43 5.11 – – – 4.93 6.25 12.07 4.67 5.46 7.90 12.37 6.01 4.48 – – – 5.15 6.28 11.92 4.86 5.61 5.32 10.16 5.75 3.93 – – – Total assets $ 502,100 $ 445,300 $ 418,200 $ 22,170 $ 16,958 $ 13,866 4.42% 3.81% 3.32% Liabilities and shareholders’ equity Deposits (5) Canada United States Other International Obligations related to securities sold short Obligations related to assets sold under repurchase agreements and securities loaned Subordinated debentures Other interest-bearing liabilities Total interest-bearing liabilities Non-interest-bearing deposits Acceptances Other liabilities Total liabilities Shareholders’ equity Preferred Common $ 167,015 $ 161,866 $ 147,956 $ 47,913 91,334 40,004 70,168 38,402 67,680 5,024 $ 2,018 3,666 3,724 $ 1,047 2,175 306,262 272,038 254,038 10,708 38,630 34,169 27,013 2,071 32,786 8,013 2,759 388,450 17,037 8,882 66,755 25,912 8,359 4,041 344,519 16,159 6,414 58,757 29,159 8,000 3,458 321,668 14,164 6,049 57,697 1,882 419 328 15,408 – – – 6,946 1,381 1,120 442 299 10,188 – – – 3,186 510 1,446 5,142 978 677 429 242 7,468 – – – 3.01% 4.21 4.01 3.50 5.36 5.74 5.23 11.89 3.97 – – – 2.30% 2.62 3.10 2.55 4.04 4.32 5.29 7.40 2.96 – – – 2.15% 1.33 2.14 2.02 3.62 2.32 5.36 7.00 2.32 – – – $ 481,124 $ 425,849 $ 399,578 $ 15,408 $ 10,188 $ 7,468 3.20% 2.39% 1.87% $ 1,022 $ 811 $ 19,954 18,640 832 17,790 – – – – – – Total liabilities and shareholders’ equity $ 502,100 $ 445,300 $ 418,200 $ 15,408 $ 10,188 $ 7,468 Net interest income and margin $ 502,100 $ 445,300 $ 418,200 $ 6,762 $ 6,770 $ 6,398 Net interest income and margin Canada United States International $ 257,319 $ 229,184 $ 212,562 $ 90,684 86,105 74,842 74,849 61,716 78,709 6,068 $ 136 558 5,379 $ 774 617 4,870 922 606 Total $ 434,108 $ 378,875 $ 352,987 $ 6,762 $ 6,770 $ 6,398 – – 3.07% 1.35% 2.36% .15 .65 1.56% – – 2.29% 1.52% 2.35% 1.03 .82 1.79% – – 1.79% 1.53% 2.29% 1.49 .77 1.81% (1) (2) (3) (4) (5) Geographic classification for selected assets and liabilities is based on the domicile of the booking point of the subject assets and liabilities. Average amounts are calculated using methods intended to approximate the average of the daily balances for the period. Interest income includes loan fees of $348 million (2005 – $343 million; 2004 – $336 million). Average balances include impaired loans. Deposits include savings deposits with average balances of $46 billion (2005 – $46 billion; 2004 – $45 billion), interest expense of $.4 billion (2005 – $.3 billion; 2004 – $.2 billion) and average rates of .8% (2005 – .6%; 2004 – .5%). Deposits also include term deposits with average balances of $206 billion (2005 – $181 billion; 2004 – $169 billion), interest expense of $8.3 billion (2005 – $5.3 billion; 2004 – $4.0 billion) and average rates of 4.02% (2005 – 2.95%; 2004 – 2.34%). Royal Bank of Canada Annual Report 2006 92 Management’s Discussion and Analysis Change in net interest income (1) Table 57 (C$ millions) Assets Deposits with other banks Canada United States Other International Securities Trading account Investments Loan substitute Assets purchased under reverse repurchase agreements and securities borrowed Loans Canada Residential mortgages Personal Credit cards Business and government United States Other International 2006 vs. 2005 Increase (decrease) due to changes in 2005 vs. 2004 Increase (decrease) due to changes in Average volume (2) Average rate (2) Net change Average volume (2) Average rate (2) Net change $ $ 10 11 35 863 21 (1) – 89 104 482 208 (1) $ $ 10 100 139 $ 5 4 4 1,345 229 (2) 506 (125) 16 $ 18 44 53 487 127 – 23 48 57 993 2 16 404 1.069 1,473 8 690 698 383 266 (1) 162 108 173 66 380 9 (143) 376 139 449 646 8 19 484 312 362 251 70 114 (42) 43 (175) (9) 9 (55) 534 153 187 242 79 59 492 196 Total interest income $ 2,434 $ 2,778 $ 5,212 $ 1,216 $ 1,876 $ 3,092 Liabilities Deposits Canada United States International Obligations related to securities sold short Obligations related to assets sold under repurchase agreements and securities loaned Subordinated debentures Other interest-bearing liabilities Total interest expense Net interest income $ $ $ 122 238 754 197 341 (18) (115) $ 1,178 733 737 493 421 (5) 144 1,300 971 1,491 690 762 (23) 29 $ $ 1,519 915 $ $ 3,701 $ 5,220 $ (923) $ (8) $ 311 22 55 280 (83) 19 42 646 570 $ $ $ $ 227 515 674 123 526 (6) 15 538 537 729 403 443 13 57 2,074 $ 2,720 (198) $ 372 (1) (2) Geographic classification for selected assets and liabilities is based on the domicile of the booking point of the subject assets and liabilities. 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. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 93 Diversification by credit portfolio Table 58 (C$ millions) Residential mortgages Personal Credit card Consumer Agriculture Automotive (1) Consumer goods Energy Financial services Forest products Government Industrial products Mining and metals Real estate and related Technology and media Transportation and environment (1) Other Business and government (2) Total loans and acceptances Total allowance for loan losses 2006 2005 2004 2003 2002 $ 96,675 44,902 7,155 $ 91,043 41,045 6,200 $ 81,998 36,848 6,456 $ 75,790 32,186 4,816 $ 72,840 30,588 4,914 $ 148,732 $ 138,288 $ 125,302 $ 112,792 $ 108,342 $ 5,708 3,053 4,864 6,064 5,756 1,166 2,719 3,733 1,161 16,421 2,395 2,581 14,694 $ 5,509 2,637 4,731 5,648 2,661 1,249 2,444 3,229 553 13,977 2,310 2,062 13,690 $ 5,207 2,451 4,821 3,493 1,609 1,181 2,319 2,887 671 12,420 2,192 2,749 11,442 $ 4,955 2,427 5,180 3,711 2,315 1,554 2,096 3,012 1,056 12,463 2,782 3,290 10,759 $ 5,039 2,164 5,246 6,775 5,518 1,670 1,323 3,728 1,630 11,673 4,630 4,518 13,568 $ 70,315 $ 60,700 $ 53,442 $ 55,600 $ 67,482 $ 219,047 $ 198,988 $ 178,744 $ 168,392 $ 175,824 (1,409) (1,498) (1,644) (2,055) (2,203) Total loans and acceptances, net of allowance for loan losses $ 217,638 $ 197,490 $ 177,100 $ 166,337 $ 173,621 (1) (2) Commencing in 2002, certain amounts were reclassified from the transportation and environment sector grouping to the automotive group. Includes small business loans of $12,817 million in 2006 (2005 – $10,757 million; 2004 – $10,137 million; 2003 – $9,705 million; 2002 – $9,470 million). For further details, see Table 64. Diversification by geographical area (1) Table 59 (C$ millions) Canada Residential mortgages Personal Credit cards Business and government United States Residential mortgages Personal Credit cards Business and government Other International Residential mortgages Personal Credit cards Business and government Total loans and acceptances Total allowance for loan losses 2006 2005 2004 2003 2002 $ 94,272 37,946 6,966 49,255 $ 88,808 33,986 6,024 44,929 $ 80,168 30,415 6,298 37,783 $ 73,978 26,445 4,663 36,576 $ 67,700 24,550 4,740 41,585 $ 188,439 $ 173,747 $ 154,664 $ 141,662 $ 138,575 $ 1,518 6,011 123 13,847 $ 1,375 6,248 118 12,317 $ 1,053 5,849 108 11,698 $ 1,067 5,015 107 13,213 $ 4,351 5,269 125 16,537 $ 21,499 $ 20,058 $ 18,708 $ 19,402 $ 26,282 $ $ 885 945 66 7,213 $ 860 811 58 3,454 $ 777 584 50 3,961 $ 745 726 46 5,811 789 769 49 9,360 $ 9,109 $ 5,183 $ 5,372 $ 7,328 $ 10,967 $ 219,047 $ 198,988 $ 178,744 $ 168,392 $ 175,824 (1,409) (1,498) (1,644) (2,055) (2,203) Total loans and acceptances, net of allowance for loan losses $ 217,638 $ 197,490 $ 177,100 $ 166,337 $ 173,621 (1) Geographic information is based on residence of borrower. Royal Bank of Canada Annual Report 2006 94 Management’s Discussion and Analysis Impaired loans by credit portfolio and geography (1) (C$ millions, except percentage amounts) Residential mortgages Personal Consumer Agriculture Automotive Consumer goods Energy Financial services Forest products Government Industrial products Mining and metals Real estate and related Small business (2) Technology and media Transportation and environment Other Business and government Total impaired loans (3), (4) Canada Residential mortgages Personal Business and government United States Consumer Business and government Other International Consumer Business and government Total impaired loans Specific allowance for credit losses Net impaired loans Gross impaired loans as a % of loans and acceptances Residential mortgages Personal Credit cards Consumer Business and government Total $ $ $ $ $ $ $ $ $ $ $ $ $ 2006 2005 $ $ $ $ $ $ 154 190 344 45 5 59 6 15 1 21 4 3 64 129 42 14 82 490 834 127 183 279 $ $ $ $ $ $ 136 169 305 48 2 53 46 16 10 – 2 3 54 108 48 8 71 469 774 106 161 236 Table 60 2003 2002 2004 146 189 $ 131 $ 235 335 $ 366 $ 89 $ 4 36 162 14 151 – 38 8 84 142 86 12 98 146 $ 7 48 240 45 169 – 25 57 97 169 122 136 118 131 306 437 159 39 57 243 77 199 – 53 128 115 205 225 206 145 924 $ 1,379 $ 1,851 1,259 $ 1,745 $ 2,288 $ 96 178 509 $ 110 213 741 102 275 895 589 $ 503 $ 783 $ 1,064 $ 1,272 $ 15 151 $ 16 173 $ 44 332 $ 29 332 166 $ 189 $ 376 $ 361 $ $ $ $ 19 60 79 834 (263) $ $ $ 22 60 82 774 (282) $ $ $ 17 83 100 1,259 (487) $ $ $ 14 306 320 1,745 (757) 47 537 584 13 419 432 2,288 (894) 571 $ 492 $ 772 $ 988 $ 1,394 .16% .42% 0% .23% .70% .38% .15% .36% 0% .22% .77% .39% .18% .51% 0% .27% 1.73% .70% .17% .73% 0% .32% 2.48% 1.04% .18% 1.00% 0% .40% 2.74% 1.30% Specific allowance for credit losses as a % of gross impaired loans 31.53% 36.43% 38.68% 43.38% 39.07% (1) (2) (3) (4) Geographic information is based on residence of borrower. Includes government guaranteed portions of impaired loans of $25 million in small business in 2006 (2005 – $18 million; 2004 – $24 million; 2003 – $39 million; 2002 – $64 million) and $8 million in agriculture (2005 – $5 million; 2004 – $9 million; 2003 – $9 million; 2002 – $10 million). Includes foreclosed assets of $9 million in 2006 (2005 – $17 million; 2004 – $27 million; 2003 – $34 million; 2002 – $32 million). Past due loans greater than 90 days not included in impaired loans were $305 million in 2006 (2005 – $304 million; 2004 – $219 million; 2003 – $222 million; 2002 – $217 million). Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 95 Provision for credit losses by credit portfolio and geography (1) (C$ millions, except percentage amounts) Residential mortgages Personal Credit card Consumer Agriculture Automotive Consumer goods Energy Financial services Forest products Industrial products Mining and metals Real estate and related Small business Technology and media Transportation and environment Other Business and government Total specific provision for loan losses Canada Residential mortgages Personal Credit cards Business and government United States Consumer Business and government Other International Consumer Business and government Total specific provision for loan losses Total general provision Total provision for credit losses $ $ $ $ $ $ $ $ $ $ $ $ $ $ 2004 2003 2002 Table 61 2006 6 306 163 $ 2005 2 259 194 $ 475 $ 455 $ (1) $ 3 – (53) 4 (2) (1) – (4) 54 (6) (2) 15 $ $ $ 7 482 6 296 161 44 (12) $ – 21 (20) 10 (53) (9) (1) (15) 44 (7) 7 (31) (66) $ 389 $ $ 1 247 192 (5) $ $ $ $ $ $ 7 222 167 396 7 1 (19) 50 – 3 5 (4) (7) 75 1 (35) 48 125 521 6 211 166 30 8 $ 254 155 417 – (1) 10 78 (1) 13 1 5 (12) 77 30 77 27 304 721 4 230 152 141 $ $ $ $ $ 507 $ 435 $ 413 $ 527 $ $ 12 (38) $ 15 (60) $ 13 106 $ 30 78 (26) $ (45) $ 119 $ 108 $ – 1 1 482 $ $ $ (53) $ 429 $ $ – (1) $ – (11) (1) $ (11) $ 1 85 86 389 66 455 $ $ $ 521 $ 721 (175) $ – 346 $ 721 $ $ $ $ $ 2 289 140 431 22 1 17 145 (6) 4 (2) 27 (16) 110 298 2 32 634 1,065 2 267 135 125 529 27 413 440 – 96 96 1,065 – 1,065 .62% Specific provision as a % of average loans and acceptances .23% .21% .30% .43% (1) Geographic information is based on residence of borrower. Royal Bank of Canada Annual Report 2006 96 Management’s Discussion and Analysis Allowance for credit losses by credit portfolio and geography (1) (C$ millions, except percentage amounts) Allowance at beginning of year Provision for credit losses Write-offs by portfolio Residential mortgages Personal Credit card Consumer Business and government LDC exposures Total write-offs by portfolio Recoveries by portfolio Personal Credit card Consumer Business and government Total recoveries by portfolio Net write-offs Adjustments (2) Total allowance for credit losses at end of year Canada Residential mortgages Personal Business and government United States Consumer Business and government Other International Consumer Business and government Total specific allowance for loan losses General allowance Total allowance for credit losses $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 2006 1,568 429 (5) (374) (204) 2005 1,714 455 (5) (347) (237) $ 2004 2,164 346 (7) (325) (207) 2003 2,314 721 (10) (373) (192) (583) $ (130) – (589) $ (181) – (539) $ (462) – (575) $ (407) – Table 62 2002 2,392 1,065 $ (12) (398) (178) (588) (836) (33) (713) $ (770) $ (1,001) $ (982) $ (1,457) $ $ 64 41 105 100 $ $ 69 43 112 62 $ $ 68 39 107 109 $ $ 68 37 105 65 205 $ 174 $ 216 $ 170 $ 70 38 108 90 198 (508) $ (3) (596) $ (5) (785) $ (812) $ (11) (59) (1,259) 116 1,486 $ 1,568 $ 1,714 $ 2,164 $ 2,314 $ 11 88 121 $ 9 101 120 $ 11 108 208 $ 12 129 297 220 $ 230 $ 327 $ 438 $ 3 12 15 1 27 28 263 1,223 $ $ $ $ $ 3 18 21 – 31 31 282 1,286 $ $ $ $ $ $ 5 118 $ 11 131 123 $ 142 $ – 37 37 487 1,227 $ $ $ – 177 177 757 1,407 $ $ $ 14 163 329 506 17 212 229 – 159 159 894 1,420 1,486 $ 1,568 $ 1,714 $ 2,164 $ 2,314 Key ratios Allowance for credit losses as a % of loans and acceptances Allowance for credit losses as a % of impaired loans (coverage ratio) Net write-offs as a % of average loans and acceptances .68% 178% .25% .79% 203% .32% .97% 136% .46% 1.30% 124% .49% 1.33% 101% .74% (1) (2) Geographic information is based on residence of borrower. Other adjustments include primarily foreign exchange translations on non-Canadian dollar denominated allowance for credit losses and acquisition adjustments for Provident Financial Group Inc. $6 million in the first quarter 2004; Admiralty Bancorp, Inc. $8 million. Royal Bank of Canada Annual Report 2006 Management’s Discussion and Analysis 97 Credit quality information by province (1) Table 63 (C$ millions) Loans and acceptances Atlantic provinces (2) Quebec Ontario Prairie provinces (3) B.C. and territories (4) 2006 2005 2004 2003 2002 $ 10,256 32,723 83,839 32,598 29,023 $ 10,255 26,646 78,283 31,190 27,373 $ 9,598 23,670 70,896 26,701 23,799 $ 9,191 22,564 64,351 24,084 21,472 $ 8,828 21,695 63,233 24,215 20,604 Total loans and acceptances in Canada $ 188,439 $ 173,747 $ 154,664 $ 141,662 $ 138,575 Impaired loans Atlantic provinces (2) Quebec Ontario Prairie provinces (3) B.C. and territories (4) Total impaired loans in Canada Provision for credit losses Atlantic provinces (2) Quebec Ontario Prairie provinces (3) B.C. and territories (4) $ $ $ $ 53 68 286 107 75 $ 47 44 269 78 65 $ 60 131 254 93 245 $ 81 155 348 140 340 107 90 471 177 427 589 $ 503 $ 783 $ 1,064 $ 1,272 $ 33 47 344 38 45 $ 30 7 368 44 (14) $ 34 (1) 318 31 31 $ 46 77 309 55 40 59 (5) 330 86 59 529 Total provision for credit losses in Canada $ 507 $ 435 $ 413 $ 527 $ (1) (2) (3) (4) Based on residence of borrower. Comprises Newfoundland and Labrador, Prince Edward Island, Nova Scotia and New Brunswick. Comprises Manitoba, Saskatchewan and Alberta. Comprises British Columbia, Nunavut, Northwest Territories and Yukon. Small business loans and acceptances by sector (C$ millions) Agriculture Automotive Consumer goods Energy Financial services Forest products Government Industrial products Mining and metals Real estate and related Technology and media Transportation and environment Other Total small business loans $ $ $ 2006 248 601 2,043 284 73 366 177 1,377 88 2,565 300 774 3,921 2005 715 490 1,728 182 78 311 182 1,057 57 1,982 243 549 3,183 $ 2004 519 463 1,764 150 51 276 156 999 62 1,821 232 502 3,142 $ Table 64 2002 67 377 1,583 125 93 278 187 887 69 1,737 204 552 3,311 2003 70 462 1,777 137 97 298 161 952 65 1,777 242 503 3,164 $ 12,817 $ 10,757 $ 10,137 $ 9,705 $ 9,470 Royal Bank of Canada Annual Report 2006 98 Management’s Discussion and Analysis Consolidated Financial Statements Consolidated Financial Statements Notes to the Consolidated Financial Statements 100 Management’s responsibility for financial 106 Note 1 Significant accounting policies and 132 Note 20 Pensions and other reporting estimates 100 Report of Independent Registered Chartered Accountants 101 Management’s report on internal control over financial reporting 101 Report of Independent Registered Chartered Accountants 102 Consolidated Balance Sheets 103 Consolidated Statements of Income 104 Consolidated Statements of Changes in 112 Note 2 Estimated fair value of financial instruments 113 Note 3 Securities 115 Note 4 Loans 116 Note 5 Securitizations 118 Note 6 Variable interest entities 119 Note 7 Derivative financial instruments 123 Note 8 Premises and equipment 123 Note 9 RBC Dexia Investor Services joint post-employment benefits 134 Note 21 Stock-based compensation 137 Note 22 Trading revenue 137 Note 23 Business realignment charges 138 Note 24 Income taxes 139 Note 25 Earnings per share 140 Note 26 Concentrations of credit risk 140 Note 27 Guarantees, commitments and contingencies 144 Note 28 Contractual repricing and maturity Shareholders’ Equity venture schedule 105 Consolidated Statements of Cash Flows 124 Note 10 Goodwill and other intangibles 124 Note 11 Significant acquisitions and 144 Note 29 Related party transactions 145 Note 30 Results by business and geographic dispositions segment 147 Note 31 Reconciliation of Canadian and United States generally accepted accounting principles 156 Note 32 Subsequent events 125 Note 12 Other assets 126 Note 13 Deposits 127 Note 14 Insurance 127 Note 15 Other liabilities 128 Note 16 Subordinated debentures 129 Note 17 Trust capital securities 130 Note 18 Preferred share liabilities and share capital 132 Note 19 Non-controlling interest in subsidiaries Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 99 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 compli- ance 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. Report of Independent Registered Chartered Accountants To the Board of Directors and Shareholders of Royal Bank of Canada We have audited the consolidated balance sheets of Royal Bank of Canada (the “Bank”) as at October 31, 2006 and 2005 and the consoli- dated statements of income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended October 31, 2006. These consolidated 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 year ended October 31, 2006, we conducted our audit 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 years ended October 31, 2005 and 2004, we conducted our audits in accordance with Canadian generally accepted auditing standards. These standards require that we plan and perform an audit to obtain reason- able 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. 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 recom- mendation 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, 2006 In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the Bank as at October 31, 2006 and 2005 and the results of its operations and its cash flows for each of the years in the three-year period ended October 31, 2006 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 effec- tiveness of the Bank’s internal control over financial reporting as at October 31, 2006, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 29, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Bank’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Bank’s internal control over financial reporting. Deloitte & Touche LLP Independent Registered Chartered Accountants Toronto, Canada November 29, 2006 Royal Bank of Canada Annual Report 2006 100 Consolidated Financial Statements Management’s report on internal control over financial reporting Management of Royal Bank of Canada (RBC) is responsible for establish- ing 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: (i) pertain to the maintenance of records that accurately and fairly reflect, in reasonable detail, the transactions related to and dispositions of RBC’s assets (ii) 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 (iii) provide reasonable assurance regarding prevention or timely detec- tion 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 con- trols may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Report of Independent Registered Chartered Accountants To the Board of Directors and Shareholders of Royal Bank of Canada We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Royal Bank of Canada (the “Bank”) maintained effec- tive internal control over financial reporting as at October 31, 2006, 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. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of 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 reason- able 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, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circum- stances. We believe that our audit provides a reasonable basis for our opinions. 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, manage- ment, 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 Management assessed the effectiveness of RBC’s internal control over financial reporting as at October 31, 2006, based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management believes that, as at October 31, 2006, 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 at October 31, 2006. Management’s assessment of the effectiveness of RBC’s internal control over financial reporting as at October 31, 2006, 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, 2006, as stated in the Report of Independent Registered Chartered Accountants, which expressed an unqualified opinion on management’s assessment of RBC’s internal control over financial reporting and 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, 2006 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 detec- tion 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 manage- ment 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 finan- cial 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, management’s assessment that the Bank main- tained effective internal control over financial reporting as at October 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Bank maintained, in all material respects, effective internal control over financial reporting as at October 31, 2006, 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, 2006 of the Bank and our report dated November 29, 2006 expressed an unqualified opinion on those consolidated financial statements. Deloitte & Touche LLP Independent Registered Chartered Accountants Toronto, Canada November 29, 2006 Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 101 Consolidated Balance Sheets As at October 31 (C$ millions) Assets Cash and due from banks Interest-bearing deposits with banks Securities (Note 3) Trading account Investment account Loan substitute Assets purchased under reverse repurchase agreements and securities borrowed Loans (Notes 4 and 5) Residential mortgage Personal Credit cards Business and government Allowance for loan losses Other Customers’ liability under acceptances Derivative-related amounts (Note 7) Premises and equipment, net (Note 8) Goodwill (Note 10) Other intangibles (Note 10) Assets of operations held for sale Other assets (Note 12) Liabilities and shareholders’ equity Deposits (Note 13) Personal Business and government Bank Other Acceptances Obligations related to securities sold short Obligations related to assets sold under repurchase agreements and securities loaned Derivative-related amounts (Note 7) Insurance claims and policy benefit liabilities (Note 14) Liabilities of operations held for sale Other liabilities (Note 15) Subordinated debentures (Note 16) Trust capital securities (Note 17) Preferred share liabilities (Note 18) Non-controlling interest in subsidiaries (Note 19) Shareholders’ equity (Note 18) Preferred shares Common shares (1) (shares issued – 1,280,889,745 and 1,293,501,544) Contributed surplus Retained earnings Treasury shares – preferred (shares held – 93,700 and 90,600) Net foreign currency translation adjustments – common (1) (shares held – 5,486,072 and 7,052,552) 2006 2005 $ 4,401 $ 5,001 10,502 5,237 147,237 36,976 656 125,760 34,060 675 184,869 160,495 59,378 42,973 96,675 44,902 7,155 61,207 91,043 41,045 6,200 53,626 209,939 (1,409) 191,914 (1,498) 208,530 190,416 9,108 37,729 1,818 4,304 642 82 15,417 7,074 38,834 1,708 4,203 409 263 12,908 69,100 65,399 $ 536,780 $ 469,521 $ 114,040 189,140 40,343 $ 111,618 160,593 34,649 343,523 306,860 9,108 38,252 41,103 42,094 7,337 32 22,649 7,074 32,391 23,381 42,592 7,117 40 18,408 160,575 131,003 7,103 1,383 298 1,775 8,167 1,400 300 1,944 1,050 7,196 292 15,771 (2) (180) (2,004) 700 7,170 265 13,704 (2) (216) (1,774) 22,123 19,847 $ 536,780 $ 469,521 (1) The number of common shares issued and the number of common shares held as treasury shares have been adjusted retroactively for the stock dividend paid on April 6, 2006. Refer to Note 18. Gordon M. Nixon President and Chief Executive Officer Robert B. Peterson Director Royal Bank of Canada Annual Report 2006 102 Consolidated Financial Statements Consolidated Statements of Income For the year ended October 31 (C$ millions) Interest income Loans Securities Assets purchased under reverse repurchase agreements and securities borrowed Deposits with banks Interest expense Deposits Other liabilities Subordinated debentures Net interest income Non-interest income Insurance premiums, investment and fee income Trading revenue Investment management and custodial fees Securities brokerage commissions Mutual fund revenue Service charges Underwriting and other advisory fees Card service revenue Foreign exchange revenue, other than trading Securitization revenue (Note 5) Credit fees Gain on sale of investment account securities (Note 3) Other Non-interest income Total revenue Provision for credit losses (Note 4) Insurance policyholder benefits, claims and acquisition expense Non-interest expense Human resources (Notes 20 and 21) Equipment Occupancy Communications Professional fees Outsourced item processing Amortization of other intangibles (Note 10) Other Business realignment charges (Note 23) Income from continuing operations before income taxes Income taxes (Note 24) Net income before non-controlling interest Non-controlling interest in net income of subsidiaries Net income from continuing operations Net loss from discontinued operations Net income Preferred dividends (Note 18) Net gain on redemption of preferred shares Net income available to common shareholders Average number of common shares (1) (in thousands) (Note 25) Basic earnings per share (in dollars) Basic earnings per share from continuing operations (in dollars) Basic earnings (loss) per share from discontinued operations (in dollars) Average number of diluted common shares (1) (in thousands) (Note 25) Diluted earnings per share (in dollars) Diluted earnings per share from continuing operations (in dollars) Diluted earnings (loss) per share from discontinued operations (in dollars) 2006 2005 2004 $ 12,708 6,155 2,827 480 $ 10,790 4,583 1,354 231 $ 9,535 3,572 656 103 22,170 16,958 13,866 10,708 4,281 419 6,946 2,800 442 15,408 10,188 6,762 6,770 3,348 2,574 1,335 1,243 1,242 1,216 1,024 496 438 257 241 88 373 3,270 1,594 1,255 1,163 962 1,153 1,026 579 407 285 187 85 448 5,142 1,897 429 7,468 6,398 2,870 1,563 1,126 1,166 850 1,089 918 555 331 200 198 20 518 13,875 12,414 11,404 20,637 19,184 17,802 429 2,509 7,340 957 792 687 628 298 76 717 455 2,625 6,736 960 749 632 529 296 50 1,405 346 2,124 6,701 906 765 672 474 294 69 952 11,495 11,357 10,833 – 6,204 1,403 4,801 44 4,757 (29) 45 4,702 1,278 3,424 (13) 3,437 (50) 177 4,322 1,287 3,035 12 3,023 (220) $ 4,728 $ 3,387 $ 2,803 (60) – (42) 4 (31) – $ 4,668 $ 3,349 $ 2,772 1,279,956 $ 3.65 $ 3.67 (.02) $ 1,283,433 2.61 $ $ 2.65 (.04) $ 1,293,465 2.14 2.31 (.17) $ $ $ 1,299,785 $ 3.59 $ 3.61 (.02) $ 1,304,680 2.57 $ $ 2.61 (.04) $ 1,311,016 2.11 2.28 (.17) $ $ $ Dividends per share (1) (in dollars) $ 1.44 $ 1.18 $ 1.01 (1) The average number of common shares, average number of diluted common shares, basic and diluted earnings per share, as well as dividends per share, have been adjusted retroactively for the stock dividend paid on April 6, 2006. Refer to Note 25. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 103 $ 2006 2005 2004 $ $ 700 600 (250) 1,050 7,170 127 (101) 7,196 265 (2) (18) – – – 47 292 532 300 (132) 700 6,988 214 (32) 7,170 169 (6) 26 7 – 54 15 265 532 – – 532 7,018 127 (157) 6,988 85 – 56 – 34 – (6) 169 13,704 4,728 (60) (1,847) (743) (11) – 12,065 3,387 (42) (1,512) (194) – – 11,333 2,803 (31) (1,303) (735) – (2) 15,771 13,704 12,065 (2) 51 (51) (2) (216) 193 (157) – – (180) – – (2) (2) (294) 179 (47) – (54) (216) (1,774) (499) 269 (2,004) (1,556) (619) 401 (1,774) – – – – – 248 (238) (304) – (294) (893) (1,341) 678 (1,556) $ 22,123 $ 19,847 $ 17,904 Consolidated Statements of Changes in Shareholders’ Equity For the year ended October 31 (C$ millions) Preferred shares (Note 18) Balance at beginning of year Issued Redeemed for cancellation Balance at end of year Common shares (Note 18) Balance at beginning of year Issued Purchased for cancellation Balance at end of year Contributed surplus Balance at beginning of year Renounced stock appreciation rights Stock-based compensation awards Gain on redemption of preferred shares Reclassified amounts Initial adoption of AcG-15, Consolidation of Variable Interest Entities Other Balance at end of year Retained earnings Balance at beginning of year Net income Preferred share dividends (Note 18) Common share dividends (Note 18) Premium paid on common shares purchased for cancellation Issuance costs and other Cumulative effect of adopting AcG-17, Equity-Linked Deposit Contracts Balance at end of year Treasury shares – preferred (Note 18) Balance at beginning of year Sales Purchases Balance at end of year Treasury shares – common (Note 18) Balance at beginning of year Sales Purchases Reclassified amounts Initial adoption of AcG-15, Consolidation of Variable Interest Entities Balance at end of year Net foreign currency translation adjustments Balance at beginning of year Unrealized foreign currency translation gain (loss) Foreign currency gain (loss) from hedging activities Balance at end of year Shareholders’ equity at end of year Royal Bank of Canada Annual Report 2006 104 Consolidated Financial Statements Consolidated Statements of Cash Flows For the year ended October 31 (C$ millions) Cash flows from operating activities Net income from continuing operations Adjustments to determine net cash from (used in) operating activities Provision for credit losses Depreciation Business realignment charges Business realignment payments Future income taxes Amortization of other intangibles Write-down of deferred issuance costs (Gain) loss on sale of premises and equipment (Gain) loss on loan securitizations Loss on investment in associated corporations and limited partnerships (Gain) loss on sale of investment account securities Changes in operating assets and liabilities Insurance claims and policy benefit liabilities Net change in accrued interest receivable and payable Current income taxes Derivative-related assets Derivative-related liabilities Trading account securities Net change in brokers and dealers receivable and payable Other Net cash from (used in) operating activities from continuing operations Net cash from (used in) operating activities from discontinued operations 2006 2005 2004 $ 4,757 $ 3,437 $ 3,023 429 405 – (74) 144 76 – (16) (16) – (88) 220 217 (203) 1,105 (498) (21,477) (1,017) 1,036 (15,000) 4 455 414 36 (94) (482) 50 – (21) (101) – (85) 629 (5) (9) 63 391 (36,438) 1,334 804 (29,622) 95 Net cash from (used in) operating activities (14,996) (29,527) Cash flows from investing activities Change in interest-bearing deposits with banks Change in loans, net of loan securitizations Proceeds from loan securitizations Proceeds from sale of investment account securities Proceeds from maturity of investment account securities Purchases of investment account securities Change in loan substitute securities Net acquisitions of premises and equipment Change in assets purchased under reverse repurchase agreements and securities borrowed Net cash from (used in) acquisitions Net cash from (used in) investing activities from continuing operations Net cash from (used in) investing activities from discontinued operations Net cash from (used in) investing activities Cash flows from financing activities Change in deposits Issue of RBC Trust Capital Securities (RBC TruCS) Issue of subordinated debentures Repayment of subordinated debentures Issue of preferred shares Redemption of preferred shares for cancellation Issuance costs Issue of common shares Purchase of common shares for cancellation Sales of treasury shares Purchase of treasury shares Dividends paid Dividends/distributions paid by subsidiaries to non-controlling interests Change in obligations related to assets sold under repurchase agreements and securities loaned Change in obligations related to securities sold short Change in short-term borrowings of subsidiaries (5,265) (33,534) 8,139 14,709 28,203 (38,474) 19 (511) (16,405) (256) (43,375) 140 (43,235) 36,663 – – (953) 600 (250) (6) 116 (844) 244 (208) (1,807) (47) 17,722 5,861 620 1,030 (27,670) 5,607 25,628 18,405 (36,373) 26 (383) 3,976 – (9,754) 2,027 (7,727) 35,001 1,200 800 (786) 300 (132) (3) 198 (226) 179 (49) (1,469) (13) (3,092) 7,386 (628) Net cash from (used in) financing activities from continuing operations Net cash from (used in) financing activities Effect of exchange rate changes on cash and due from banks Net change in cash and due from banks Cash and due from banks at beginning of year Cash and due from banks at end of year Supplemental disclosure of cash flow information Amount of interest paid in year Amount of income taxes paid in year 57,711 38,666 14,675 57,711 38,666 14,675 (80) (600) 5,001 (122) 1,290 3,711 (17) 824 2,887 $ 4,401 $ 5,001 $ 3,711 $ 14,678 1,682 $ $ 10,109 1,987 $ $ $ 7,408 2,612 Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 105 346 387 177 – (52) 69 25 (52) (34) 9 (20) 118 (120) (895) (3,281) 4,426 (1,965) (539) 6 1,628 303 1,931 (4,320) (15,287) 3,532 18,427 38,088 (50,911) (376) (439) (5,767) 438 (16,615) 850 (15,765) 11,814 – 3,100 (990) – – – 119 (892) 248 (238) (1,295) (13) 1,977 2,150 (1,305) 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), the 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 The 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 partner- ships 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 impair- ment 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. 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 currency 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 are included in Shareholders’ equity along with related hedge and tax effects. On disposal or upon 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 which are purchased for sale in the near term are classified as Trading account securities and reported at their estimated fair value. Obligations to deliver Trading account 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 account securities are recorded in Interest income. Interest and dividends accrued on interest-bearing and equity securities sold short are recorded in Interest expense. Investments in equity and debt securities which are purchased for longer term purposes are classified as Investment account securities. These securities 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 Royal Bank of Canada Annual Report 2006 106 Consolidated Financial Statements needs. Investment account equity securities, including non-public and venture capital equity securities for which representative market quotes are not readily available, are carried at cost. Investment account debt securities are carried at amortized cost. Dividends, interest income and amortization of premiums and discounts on debt securities are recorded in Interest income. Gains and losses realized on disposal of Investment account securities, which are calculated on an average cost basis, and writedowns to reflect other-than-temporary impairment in value are included in Gain on sale of investment account securities in Non-interest income. Loan substitute securities 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. Such securities are accorded the accounting treatment applicable to loans and, if required, are reduced by an allowance for credit losses. We account for all our securities using settlement date accounting for the Consolidated Balance Sheets and trade date accounting for the Consolidated Statements of Income. 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 repur- chase 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. These agreements are carried on the Consolidated Balance Sheets at the amounts at which the securities were initially acquired plus accrued interest. Interest earned on reverse repurchase agreements is included in Interest income in our Consolidated Statements of Income. We sell securities under agreements to repurchase (repurchase agreements). Repurchase agreements are treated as collateralized bor- rowing transactions and are carried on the Consolidated Balance Sheets at the amounts at which the securities were initially sold plus accrued interest on interest-bearing securities. Interest incurred on repurchase agreements is included in Interest expense in our Consolidated Statements of Income. Loans Loans are stated net of an Allowance for loan losses and unearned income, which comprises unearned interest and unamortized loan fees. Loans 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 Provision for credit losses in the Consolidated Statements of Income. 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 col- lectibility 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. 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. Otherwise, such fees are recorded as Other liabilities and amortized to Non-interest income over the commitment or standby period. Allowances for credit losses The Allowances for credit losses are maintained at levels that manage- ment considers adequate to absorb 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 allowances relate 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 allowances are increased by the Provision for credit losses, which is charged to income, and decreased by the amount of write-offs, net of recoveries. The Allowances for credit losses for on-balance sheet items are included as a reduction to assets, and allowances relating to off-balance sheet items are included in Other liabilities. The allowances are determined based on management’s identifi- cation and evaluation of problem accounts, estimated probable losses that exist on the remaining portfolio, and other factors including the composition and credit quality of the portfolio, and changes in economic conditions. The Allowances for credit losses consist of Specific allow- ances and the General allowance. Specific allowances Specific allowances are maintained to absorb losses on both specifically identified borrowers and other homogeneous loans that have become impaired. The losses relating to identified large business and govern- ment borrowers 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 homogeneous portfolios, including residential mortgages, and personal and small business loans 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 The general allowance represents the best estimate of probable losses within the portion of the portfolio that has not yet been specifically identified as impaired. For large business and government loans and acceptances, the general allowance is based on the application of expected default and loss factors, determined by historical loss experience, delineated by loan type and rating. For homogeneous portfolios, including residential mortgages, credit cards, and personal and small business loans, the determination of the general allowance is done on a portfolio basis. The losses are estimated by the application of loss ratios determined through historical write-off experience. 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 accep- tances is reported in Liabilities – Other on the 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, inter- est rate options, foreign exchange forward contracts, currency swaps, foreign currency futures, foreign currency options and credit derivatives. Derivatives used in sales and trading activities are reported on the Consolidated Balance Sheets at their fair value. Derivatives with a positive fair value are reported as assets in Derivative-related amounts, and derivatives with a negative fair value are reported as liabilities in Derivative-related amounts. 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. Realized and unrealized gains and losses on sales and trading derivatives are recognized in Non-interest income – Trading revenue. Margin requirements and premiums paid are also included in Derivative-related amounts in assets, while premiums received are shown in Derivative-related amounts in Liabilities. 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 hedge relationship is desig- nated as a fair value hedge, a cash flow hedge, or a hedge of a foreign currency exposure of a net investment in a self-sustaining foreign operation. The hedge is documented at inception detailing the particular risk management objective and the strategy for undertaking the hedge transaction. The documentation identifies the specific asset, liability or forecasted cash flows being hedged, the risk that is being hedged, the type of derivative used and how effectiveness will be assessed. The derivative must be highly effective in accomplishing the objective of offsetting either changes in the fair value or forecasted cash flows attributable to the risk being hedged both at inception and throughout the life of the hedge. Fair value hedge transactions predominantly use interest rate swaps to hedge the changes in the fair value of an asset, liability or firm commitment. Cash flow hedge transactions predominantly use interest rate swaps to hedge the variability in forecasted cash flows. When a derivative that is held or issued for other-than-trading purposes is desig- nated and qualifies as an effective hedging instrument in a fair value or cash flow hedge, the income or expense of the derivative is recognized as an adjustment to Interest income or Interest expense of the hedged item in the same period. Foreign exchange forward contracts and foreign currency- denominated liabilities are used to manage foreign currency exposures from net investments in self-sustaining foreign operations having a functional currency other than the Canadian dollar. Foreign exchange gains and losses on these hedging instruments, net of applicable tax, are recorded in Net foreign currency translation adjustments. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 107 Note 1 Significant accounting policies and estimates (continued) Hedge accounting is discontinued prospectively when the derivative no longer qualifies as an effective hedge or the derivative is terminated or sold. The fair value of the derivative is recognized in Derivative-related amounts in assets or liabilities at that time and the gain or loss is deferred and recognized in Net interest income in the periods in which the hedged item affects income. Hedge accounting is also discontinued on the sale or early termination of the hedged item. The fair value of the derivative is recognized in Derivative-related amounts in assets or liabilities at that time and the unrealized gain or loss is recognized in Non-interest income. Other-than-trading derivatives, for which hedge accounting has not been applied, including total return swaps, certain warrants, loan commitments and derivatives embedded in equity-linked deposit contracts, are carried at fair value on a gross basis as Derivative-related amounts in assets and liabilities with changes in fair value recorded in Non-interest income or Non-interest expense. These other-than-trading derivatives are eligible for designation in future hedging relation- ships. Upon designation of a new effective hedging relationship, any previously recorded fair value on the Consolidated Balance Sheets is amortized to Net interest income. For derivatives that are carried at fair value and whose fair value is not evidenced at inception by quoted market prices, other current market transactions or observable market inputs, we defer the initial trading profits. The deferred amounts are recognized when they become realized through the receipt and/or payment of cash or once the fair value is observable in the market. Premises and equipment Premises and equipment are stated at cost less accumulated depre- ciation. Depreciation is recorded principally on the 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, 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 acquisition of subsidiaries 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. It is defined by GAAP as the reporting level at which goodwill is tested for impairment, which 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 impair- ment. 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. Royal Bank of Canada Annual Report 2006 108 Consolidated Financial Statements 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 the 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 estab- lished to reduce future income tax assets to the amount more likely than not to be realized. In addition, the 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. These plans include registered defined benefit pension plans, supplemental pension plans, defined contribu- tion 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 3 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 aver- age 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 begin- ning 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 recog- nized 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. 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 con- tributions 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 dur- ing 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. These plans are settled in our common shares or cash and the obligations are accrued over their vesting period. For share-settled awards, our accrued obliga- tions 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 these plans, net of related hedges, are recorded as Non-interest expense – Human Resources in our Consolidated Statements of Income with a corre- sponding 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 to 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 them to independent special purpose entities (SPEs) or trusts that issue securities to investors. These transactions are accounted for as sales and the loans are removed from our Consolidated Balance Sheets when we are deemed to have surren- dered control over such assets and have received consideration other than beneficial interests in these transferred loans. For control to be sur- rendered, 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 trans- ferred loans or, if the purchaser is a Qualifying Special Purpose Entity as described in the Canadian Institute of Chartered Accountants (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 of these conditions is not met, the transfer is consid- ered to be a secured borrowing, the loans remain on our Consolidated Balance Sheets, and the proceeds are recognized as a liability. We often retain interests in the securitized loans, such as interest- only strips or servicing rights and, in some cases, cash reserve accounts. Retained interests in securitizations that can be contractually prepaid or otherwise settled in such a way that we would not recover substantially all of our recorded investment are classified as Investment account securities and subject to periodic impairment review. Gains on a transaction accounted for as a sale are recognized in Non-interest income and are dependent on the previous carrying amount of the loans involved in the transfer, which is allocated between the loans sold and the retained interests based on their relative fair value at the date of 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 included in Investment account securities. 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, 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 the life and property and casualty insurance are included in Insurance claims and policy benefit liabilities. Realized gains and losses on disposal of fixed income investments that support life insurance liabilities are 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 are held to support non-universal life insur- ance products, the realized gains and losses are 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 values and adjusted carrying costs of these equi- ties are reduced quarterly by 5%. Equities held to support universal life insurance products are carried at market value. Realized and unrealized gains or losses on these equities are included in Insurance premiums, investment and fee income. Specific investments are written down to market value or the net realizable value if it is determined that any impairment in value is other-than-temporary. The writedown is recorded against Insurance premiums, investment and fee income in the period the impairment is recognized. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 109 Note 1 Significant accounting policies and estimates (continued) Acquisition costs for new insurance business consist of commis- sions, premium taxes, certain underwriting costs and other costs that vary with and are primarily related to 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 matu- rity 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 the 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. 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, excluding 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 were assumed to be issued under securities or contracts that entitled their holders to obtain common shares in the future, to the extent such entitlement is not subject to unresolved contin- gencies. 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, variable interest entities, pensions and other post-employment benefits 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. Royal Bank of Canada Annual Report 2006 110 Consolidated Financial Statements Significant accounting changes Implicit variable interests On November 1, 2005, we adopted CICA Emerging Issues Committee Abstract No. 157, Implicit Variable Interests under AcG-15 (EIC-157). This EIC clarifies that implicit variable interests are implied financial interests in an entity that change with changes in the fair value of the entity’s net assets exclusive of variable interests. An implicit variable interest is similar to an explicit variable interest except that it involves absorbing and/or receiving variability indirectly from the entity. The identification of an implicit variable interest is a matter of judgment that depends on the relevant facts and circumstances. The implementation of this EIC did not have a material impact on our consolidated financial position or results of operations. Change in financial statement presentation During the year, we reclassified on our Consolidated Statements of Income changes in the fair value of certain derivative instruments desig- nated as economic hedges of our stock-based compensation plans from Non-interest income – Other to Non-interest expense – Human resources in order to more appropriately reflect the purpose of these instruments and our management of these compensation exposures. The impact of the reclassification on prior periods resulted in corresponding decreases in both Non-interest income – Other and Non-interest expense – Human resources. For the years ended October 31, 2006, 2005 and 2004, $36 million, $31 million and $nil were reclassified, respectively. Certain other comparative amounts have also been reclassified to conform to the current year’s presentation. Future accounting changes Financial instruments In 2005, the CICA issued three new accounting standards: Handbook Section 1530, Comprehensive Income (Section 1530), Handbook Section 3855, Financial Instruments – Recognition and Measurement (Section 3855), and Handbook Section 3865, Hedges (Section 3865). These new standards became effective for us on November 1, 2006. Comprehensive Income Section 1530 introduces Comprehensive income which is comprised of Net income and Other comprehensive income and represents changes in Shareholders’ equity during a period arising from transactions and other events with non-owner sources. Other comprehensive income (OCI) includes unrealized gains and losses on financial assets classified as available-for-sale, unrealized foreign currency translation amounts net of hedging arising from self-sustaining foreign operations, and changes in the fair value of the effective portion of cash flow hedging instruments. Our Consolidated Financial Statements will include a Consolidated Statement of Comprehensive Income while the cumula- tive amount, Accumulated other comprehensive income (AOCI), will be presented as a new category of Shareholders’ equity in the 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 deriva- tives be recognized on the balance sheet when we become a party to the contractual provisions of the financial instrument or a non-financial derivative contract. All financial instruments should 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 liabilities. Financial assets and financial liabilities held-for-trading will be measured at fair value with gains and losses recognized in Net income. Financial assets held-to-maturity, loans and receivables and financial lia- bilities other than those held-for-trading will be measured at amortized cost using the effective interest method of amortization. Available- for-sale financial assets will be 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 will be measured at cost. Derivative instruments must be recorded on the balance sheet at fair value including those derivatives that are embedded in financial instrument or other contracts but are not closely related to the host financial instrument or contract, respectively. Changes in the fair values of derivative instruments will be recognized in Net income, except for derivatives that are designated as a cash flow hedge, the fair value change for which will be recognized in OCI. Section 3855 permits an entity to designate any financial instrument as held-for-trading on initial recognition or adoption of the standard, even if that instrument would not otherwise satisfy the definition of held-for-trading set out in Section 3855. Instruments that are classified as held-for-trading by way of this “fair value option” must have reliable fair values and are subject to additional conditions and disclosure requirements set out by the OSFI. Other significant accounting implications arising on adoption of Section 3855 include the initial recognition of certain financial guar- antees at fair value on the balance sheet and the use of the effective interest method of amortization for any transaction costs or fees, premiums or discounts earned or incurred for financial instruments measured at amortized cost. Hedges Section 3865 specifies the criteria under which hedge accounting can be applied and how hedge accounting should be executed for each of the permitted hedging strategies: fair value hedges, cash flow hedges and hedges of a foreign currency exposure of a net investment in a self-sustaining foreign operation. In a fair value hedging relationship, the carrying value of the hedged item will be adjusted by gains or losses attributable to the hedged risk and recognized in Net income. The changes in the fair value of the hedged item, to the extent that the hedging relationship is effective, will be offset by changes in the fair value of the hedging derivative. In a cash flow hedging relationship, the effective portion of the change in the fair value of the hedging derivative will be recognized in OCI. The ineffective portion will be recognized in Net income. The amounts recognized in AOCI will be reclassified to Net income in the periods in which net income is affected by the variability in the cash flows of the hedged item. 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 will be recognized in OCI and the ineffective portion is recognized in Net income. For hedging relationships existing prior to adopting Section 3865 that are continued and qualify for hedge accounting under the new standard, the transition accounting is as follows: (1) Fair value hedges – any gain or loss on the hedging instrument is recognized in the opening balance of retained earnings on transition and the carrying amount of the hedged item is adjusted by the cumulative change in fair value that reflects the designated hedged risk and the adjustment is included in the opening balance of retained earnings on transition; (2) Cash flow hedges and hedge of a net investment in a self-sustaining foreign operation – any gain or loss on the hedging instrument that is determined to be the effective portion is recognized in AOCI and the ineffectiveness in the past periods is included in the opening balance of retained earnings on transition. Deferred gains or losses on the hedging instrument with respect to hedging relationships that were discontinued prior to the transition date but qualify for hedge accounting under the new standards will be recognized in the carrying amount of the hedged item and amortized to Net income over the remaining term of the hedged item for fair value hedges, and for cash flow hedges it will be recognized in AOCI and reclassified to Net income in the same period during which the hedged item affects Net income. However, for discontinued hedging relation- ships that do not qualify for hedge accounting under the new standards, the deferred gains and losses are recognized in the opening balance of retained earnings on transition. In October, 2006, the CICA’s Accounting Standards Board issued a Board Notice, Hedges, Section 3865, in order to provide guidance with respect to the transition provisions for deferred gains or losses on continuing and discontinued hedging relationships. The amended version of Section 3865 incorporating the clarifying guidance is expected to be issued in December 2006, with early adoption permitted. We adopted the proposed amendments on November 1, 2006. Impact of adopting Sections 1530, 3855 and 3865 The transition adjustment attributable to the following will be recog- nized in the opening balance of retained earnings as at November 1, 2006: (i) financial instruments that we will classify as held-for-trading and that were not previously recorded at fair value, (ii) the difference in the carrying amount of loans and deposits prior to November 1, 2006, and the carrying amount calculated using the effective interest rate from inception of the loan, (iii) the ineffective portion of cash flow hedges, (iv) deferred gains and losses on discontinued hedging relationships that do not qualify for hedge accounting under the new standards, (v) unamortized deferred net realized gains or losses on investments that support life insurance liabilities, and (vi) the consequential effect on insurance claims and policy benefit liabilities due to remeasurement of financial assets supporting these liabilities. Adjustments arising due to remeasuring financial assets classified as available-for-sale and hedging instruments designated as cash flow hedges will be recognized in the opening balance of Accumulated other comprehensive income. Neither of the transition amounts that will be recorded in the open- ing retained earnings or in the opening AOCI balance on November 1, 2006 is expected to be material to our consolidated financial position. The tax consequences, if any, of the new standards on the transi- tion or subsequent accounting are unknown. The tax authorities are currently reviewing the standards to determine any such implications. Stock-based compensation On July 6, 2006, the Emerging Issues Committee (EIC) issued Abstract No. 162, Stock-Based Compensation for Employees Eligible to Retire Before the Vesting Date (EIC-162). This EIC clarifies that the compensa- tion cost attributable to options and awards, granted to employees who are eligible to retire or will become eligible to retire during the vesting period, should be recognized immediately if the employee is eligible to retire on the grant date or over the period between the grant date to the date the employee becomes eligible to retire. This EIC became effective for us on November 1, 2006, and requires retroactive application to all stock-based compensation awards accounted for in accordance with the CICA Handbook Section 3870, Stock-Based Compensation and Other Stock-Based Payments (CICA 3870). Our current recognition policy for stock-based compensation is consistent with this guidance. Variability in variable interest entities On September 15, 2006, the EIC issued Abstract No. 163, Determining the Variability to be Considered in Applying AcG-15 (EIC-163). This EIC provides additional clarification on how to analyze and consolidate VIEs. EIC-163 will be effective for us on February 1, 2007 and its implemen- tation will result in the deconsolidation of certain investment funds. However, the impact is not expected to be material to our consolidated financial position or results of operations. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 111 Note 2 Estimated 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 value is based on quoted market prices when available. However, when financial instruments lack an available trading market, fair value is based on prevailing market rates for instruments with similar charac- teristics and risk profile or internal or external valuation models 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. These assump- tions reflect the risks inherent in the financial instrument. Valuation adjustments are required to adjust the quoted market prices or valua- tion model outputs for additional market factors which are required to ensure the financial instruments are recorded at fair value. Adjustments for counterparty credit risk are calculated to include the credit quality of the counterparty in determining the fair value of derivative transactions. The market-based parameters used in the derivative valuation models do not take into account the credit quality of the counterparties to the transactions. As a result, we calculate a valuation adjustment for each counterparty in arriving at the fair value of the transactions reported. We have documented internal policies that detail our processes for determining fair value, including the methodologies used in establish- ing our valuation adjustments. These methodologies are consistently applied and periodically reviewed by Group Risk Management. The aggregate fair value amounts represent point-in-time esti- mates only and should not be interpreted as the amounts realizable in an immediate settlement of the instruments. Liquidity adjustments are calculated when market prices are not The following table presents the carrying value and estimated fair 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. value of our financial assets and liabilities; accordingly, it does not reflect the value of assets and liabilities that are not considered financial instru- ments, such as premises and equipment, goodwill and other intangibles. 2006 Estimated fair value Book value Difference Book value 2005 Estimated fair value Difference Financial assets Cash and deposits with banks Securities Assets purchased under reverse repurchase agreements and securities borrowed Loans (net of allowance for loan losses) Derivative-related amounts Other assets Financial liabilities Deposits Derivative-related amounts Other liabilities Subordinated debentures Trust capital securities Preferred share liabilities $ 14,903 184,869 $ 14,903 185,239 $ – 370 $ 10,238 160,495 $ 10,238 160,684 $ 59,378 208,530 37,733 22,660 59,378 208,638 37,682 22,660 $ $ 343,523 42,340 28,736 7,103 1,383 298 $ 343,312 42,108 28,736 7,384 1,532 304 – 108 (51) – 211 232 – (281) (149) (6) 42,973 190,416 39,008 18,194 42,973 190,506 39,123 18,194 $ 306,860 43,001 24,330 8,167 1,400 300 $ 308,047 42,817 24,330 8,503 1,582 310 $ (1,187) 184 – (336) (182) (10) – 189 – 90 115 – Methodologies and assumptions used to estimate fair value of financial instruments Financial instruments valued at carrying value Due to their short-term nature, the fair values of Cash and deposits with banks and Assets purchased under reverse repurchase agreements and securities borrowed are assumed to approximate their carrying values. Securities The fair values of securities are based on quoted market prices, when available. If quoted market prices are not available, fair values are estimated using quoted market prices of similar securities or other third-party information. Liquidity adjustments, including adjustments for resale restrictions greater than one year, are recorded as appropriate. Loans The fair values of the loans and deposits portfolios are based on an assessment of interest rate risk and credit risk. Fair value is determined under a discounted cash flow methodology using a discount rate based on interest rates currently charged for new loans with similar terms and remaining maturities, adjusted for a credit risk factor, which is reviewed at least annually. For certain variable rate loans that reprice frequently and for loans without a stated maturity, fair values are assumed to be equal to carrying values. Derivative financial instruments The fair values of derivatives are equal to the book value, with the exception of amounts relating to derivatives that have been designated and have qualified for hedge accounting. The fair values of exchange-traded derivatives are based on quoted market prices. The fair values of over-the-counter derivatives are based on prevailing market rates for instruments with similar characteristics and maturi- ties, net present value analysis, or are determined by using pricing models that incorporate current market and contractual prices of the underlying instruments, time value of money, yield curve and volatility factors. Counterparty credit risk and liquidity valuation adjustments are recorded, as appropriate. Other assets/liabilities The fair values of Other assets and Other liabilities approximate their carrying values. Deposits The fair values of fixed-rate deposits with a fixed maturity are determined by discounting the expected future cash flows, using market interest rates currently offered for deposits of similar terms and remaining maturities (adjusted for early redemptions where appropriate). The fair values of deposits with no stated maturity or deposits with floating rates are assumed to be equal to their carrying values. Subordinated debentures The fair values of subordinated debentures are based on quoted market prices for similar issues or current rates offered to us for debt of the same remaining maturity. Trust capital securities and preferred share liabilities The fair values of Trust capital securities and preferred share liabilities are based on quoted market prices. Royal Bank of Canada Annual Report 2006 112 Consolidated Financial Statements Note 3 Securities Within 3 months 3 months to 1 year 1 to 5 years Over 5 years to 10 years Over 10 years With no specific maturity 2006 Total 2005 Total 2004 Total Term to maturity (1) $ 2,148 1,649 $ 4,646 1,379 $ 2,547 493 $ 1,518 3,331 $ $ 13,900 $ 11,814 $ 11,082 1,794 8,687 9,142 1,071 7 81 61 2,799 5,702 – 1,148 206 1,528 – 1,355 21,247 – 1,587 269 3,375 – 29 3,752 – 688 1,104 2,438 – – 3,783 – 4,658 3,841 7,715 6,476 2,281 7,375 – – 534 57,831 766 5,245 44,139 57,831 998 8,705 33,714 45,710 3,844 1,017 8,689 1,078 4,973 24,895 31,950 – – – – – 18,931 13,518 31,509 12,052 12,862 58,365 147,237 125,760 89,322 86 86 4.4% 55 55 4.5% 6 6 4.0% 368 364 2.4% 2 2 4.1% 490 488 4.0% 64 65 5.4% 1,419 1,428 5.2% 2,514 2,539 4.2% 245 247 4.5% 449 421 4.6% 982 953 3.6% 241 241 4.3% 5,544 5,474 3.9% 2,321 2,327 4.8% 3,726 3,766 4.6% 208 211 4.6% 363 373 4.7% 45 45 4.7% 286 289 5.5% 91 93 4.6% 1,242 1,231 5.4% 158 158 5.2% 1,266 1,277 4.6% 13 13 3.6% 1,023 1,259 5.9% 12 12 5.3% – – – 48 49 – 4,514 4,484 5.2% 559 559 5.5% 2,148 2,279 5.5% – – – – – – – – – – – – – – – – – – – – – 362 362 – 2,537 2,592 2,899 2,954 3,649 3,677 4.2% 1,687 1,935 5.4% 536 508 4.5% 1,678 1,648 3.6% 758 761 2.6% 11,805 11,692 4.5% 3,164 3,171 5.0% 11,162 11,360 4.8% 2,537 2,592 36,976 37,344 6,214 6,205 3.6% 2,035 2,229 4.9% 633 628 2.2% 2,199 2,139 2.5% 1,595 1,599 1.9% 8,254 8,183 4.4% 1,442 1,445 4.2% 10,676 10,839 3.7% 1,012 974 34,060 34,241 6,898 6,939 3.4% 2,010 2,118 5.2% 475 466 4.1% 3,419 3,388 2.4% 1,725 1,739 1.2% 6,038 6,082 4.4% 1,392 1,395 3.0% 15,948 16,121 2.8% 1,018 1,022 38,923 39,270 – – – – – – – – – – 3,589 3,596 2,490 2,494 16,022 15,968 3,659 3,677 8,317 8,655 Trading account Canadian government debt $ 3,041 U.S. government debt 2,290 Other OECD government debt (2) Mortgage-backed securities Asset-backed securities Corporate debt and other debt Bankers’ acceptances Certificates of deposit Other Equities 705 1,062 9,121 – 164 2,255 293 Investment account Canadian government debt Federal Amortized cost Estimated fair value Yield (3) Provincial and municipal Amortized cost Estimated fair value Yield (3) U.S. government debt Federal Amortized cost Estimated fair value Yield (3) State, municipal and agencies Amortized cost Estimated fair value Yield (3) Other OECD government debt (2) Amortized cost Estimated fair value Yield (3) Mortgage-backed securities Amortized cost Estimated fair value Yield (3) Asset-backed securities Amortized cost Estimated fair value Yield (3) Corporate debt and other debt Amortized cost Estimated fair value Yield (3) Equities Cost Estimated fair value 828 828 4.2% 1 1 6.1% 24 24 3.3% 42 42 2.5% 376 376 1.3% 15 15 5.7% 62 62 4.4% 2,241 2,248 5.1% Amortized cost Estimated fair value Loan substitute Cost Estimated fair value Total carrying value of securities Total estimated fair value of securities – – – – – – – – 400 400 256 258 656 658 675 683 701 715 $ 22,520 $ 16,008 $ 47,531 $ 15,711 $ 21,579 $ 61,520 $ 184,869 $ 160,495 $ 128,946 $ 22,527 $ 16,012 $ 47,477 $ 15,729 $ 21,917 $ 61,577 $ 185,239 $ 160,684 $ 129,307 (1) (2) (3) Actual maturities may differ from contractual maturities shown above, since borrowers may have the right to prepay obligations with or without prepayment penalties. OECD stands for Organisation for Economic Co-operation and Development. The weighted average yield is based on the carrying value at the end of the year for the respective securities. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 113 Note 3 Securities (continued) Unrealized gains and losses on Investment account securities Canadian government debt Federal Provincial and municipal U.S. government debt Federal State, municipal and agencies Other OECD government debt Mortgage-backed securities Asset-backed securities Corporate debt and other debt Equities 2006 2005 Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value Amortized cost Gross unrealized gains Gross unrealized losses Estimated fair value $ 3,649 1,687 $ 536 1,678 758 11,805 3,164 11,162 2,537 $ 36,976 $ 29 248 – 5 4 17 11 238 110 662 $ (1) $ 3,677 1,935 – $ 6,214 2,035 $ (28) (35) (1) (130) (4) (40) (55) 508 1,648 761 11,692 3,171 11,360 2,592 633 2,199 1,595 8,254 1,442 10,676 1,012 $ (294) $ 37,344 $ 34,060 $ 16 195 4 – 5 15 6 204 17 462 $ (25) $ 6,205 2,229 (1) (9) (60) (1) (86) (3) (41) (55) 628 2,139 1,599 8,183 1,445 10,839 974 $ (281) $ 34,241 Realized gains and losses on sale of Investment account securities Realized gains Realized losses and writedowns Gain on sale of Investment account securities 2006 2005 $ $ 177 (89) 88 $ $ 141 (56) 85 $ $ 2004 136 (116) 20 Fair value and unrealized losses position for Investment account securities as at October 31, 2006 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 Provincial and municipal U.S. government debt Federal State, municipal and agencies Other OECD government debt Mortgage-backed securities Asset-backed securities Corporate debt and other debt Equities $ $ – 10 61 56 387 4,512 120 602 125 Total temporarily impaired securities $ 5,873 $ 1 – 1 1 1 63 1 6 1 75 $ $ 18 24 85 1,157 – 4,492 2,002 1,093 373 – – 27 34 – 67 3 34 54 $ $ 18 34 146 1,213 387 9,004 2,122 1,695 498 $ 9,244 $ 219 $ 15,117 $ 1 – 28 35 1 130 4 40 55 294 The unrealized losses for Canadian government debt, U.S. government debt, mortgage-backed securities and asset-backed securities were caused by increases in interest rates. The contractual terms of these investments either do not permit the issuer to settle the securities at a price less than the amortized costs of the investment or permit prepay- ment 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. Unrealized losses for corporate debt and other debt were caused by either increases in interest rates or, in some cases, credit rating downgrades; however, given that 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 all amounts due 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, 2006. 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, 2006, as we have the ability and intent to hold them for a reasonable period of time until the recovery of fair value. Royal Bank of Canada Annual Report 2006 114 Consolidated Financial Statements Note 4 Loans (1) Canada Residential mortgage Personal Credit card Business and government United States Residential mortgage Personal Credit card Business and government Other International Residential mortgage Personal Credit card Business and government Total loans (2) Allowance for loan losses Total loans net of allowance for loan losses (1) (2) Includes all loans booked by location, regardless of currency or residence of borrower. Loans are net of unearned income of $62 million (2005 – $67 million). Loan maturities and rate sensitivity 2006 2005 $ 94,272 37,946 6,966 37,053 $ 88,808 33,986 6,024 34,443 176,237 163,261 1,518 6,011 123 14,935 1,375 6,248 118 13,517 22,587 21,258 885 945 66 9,219 11,115 860 811 58 5,666 7,395 209,939 (1,409) 191,914 (1,498) $ 208,530 $ 190,416 Maturity term (1) Rate sensitivity Under 1 year 1 to 5 years Over 5 years Total Floating Fixed rate Non-rate- sensitive Total $ 20,678 $ 68,401 $ 34,386 7,155 39,520 7,925 – 16,428 7,596 $ 96,675 $ 21,257 $ 75,391 $ 2,591 – 5,259 44,902 7,155 61,207 34,338 189 40,097 10,555 5,542 21,018 $ 101,739 $ 92,754 $ 15,446 $ 209,939 $ 95,881 $ 112,506 $ (1,409) $ 208,530 27 $ 96,675 44,902 7,155 61,207 9 1,424 92 1,552 $ 209,939 (1,409) $ 208,530 As at October 31, 2006 Residential mortgage Personal Credit card Business and government Total loans Allowance for loan losses Total loans net of allowance for loan losses (1) Based on the earlier of contractual repricing or maturity date. Impaired loans (1), (2) Residential mortgage Personal Business and government 2006 Specific allowance $ (13) $ (90) (160) $ Gross 154 190 490 Net 141 100 330 $ $ 834 $ (263) $ 571 $ 2005 Net 126 66 300 492 (1) (2) There are $305 million (2005 – $304 million) of loans that are contractually 90 days past due but are not considered impaired. Average balance of gross impaired loans was $805 million (2005 – $903 million). Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 115 Note 4 Loans (continued) Allowance for loan losses Residential mortgage Personal Credit card Business and government Specific allowances General allowance (2) Total allowance for credit losses Allowance for off-balance sheet and other items (3) 2006 Write-offs Recoveries Provision for credit losses Adjustments (1) Balance at beginning of year $ 10 103 – 169 $ (5) $ (374) (204) (130) $ 282 1,286 $ 1,568 (70) $ $ (713) $ – (713) $ – $ $ $ – 64 41 100 205 – 205 – $ $ $ 7 306 163 6 482 (53) 429 – 2005 Balance at end of year 10 103 – 169 $ Balance at end of year 13 90 – 160 $ 1 (9) – 15 7 (10) $ 263 1,223 $ 282 1,286 (3) $ 1,486 (77) (7) $ 1,568 (70) Total allowance for loan losses $ 1,498 $ (713) $ 205 $ 429 $ (10) $ 1,409 $ 1,498 (1) (2) (3) Primarily represent the translation impact of foreign currency-denominated Allowance for loan losses. Includes $77 million (2005 – $70 million) related to off-balance sheet and other items. The allowance for off-balance sheet and other items is reported separately under Other liabilities. Net interest income after provision for credit losses Net interest income Provision for credit losses Net interest income after provision for credit losses 2006 6,762 429 $ 2005 6,770 455 $ 2004 6,398 346 6,333 $ 6,315 $ 6,052 $ $ Note 5 Securitizations The following table summarizes our securitization activities for 2006, 2005 and 2004 (1): Securitized and sold Net cash proceeds received Asset-backed securities purchased Retained rights to future excess interest Pre-tax gain on sale Securities created and retained as Investment account securities Credit card loans $ 1,200 400 794 9 3 2006 Residential mortgage loans (3) $ 6,329 6,210 – 121 2 – 7,262 Commercial mortgage loans Credit card loans $ 1,200 600 596 8 4 $ 718 729 – – 11 – 2005 Residential mortgage loans (3) $ 3,752 3,739 – 100 87 2004 (2) Commercial mortgage loans Residential mortgage loans (3) Commercial mortgage loans $ $ 655 667 – – 12 $ 3,074 3,035 – 75 36 486 497 – – 11 – – 2,706 – 1,903 (1) We did not recognize a servicing asset or servicing liability for our servicing rights with respect to the securitized loans as we received adequate compensation for our services. (2) (3) There was no credit card loans securitization in 2004. All residential mortgage loans securitized are government guaranteed. 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. Cash flows from securitizations (1) 2006 Residential mortgage loans Variable rate Fixed rate Credit card loans 2005 Residential mortgage loans Variable rate Fixed rate Credit card loans 2004 Residential mortgage loans (2) Fixed rate Credit card loans Proceeds reinvested in revolving securitizations Cash flows from retained interests in securitizations $ 17,107 $ 466 $ 2,251 $ 12,076 $ 419 $ 1,520 $ 10,028 $ 1,202 187 10 111 118 2 81 84 46 (1) (2) This analysis is not applicable for commercial mortgage loans securitizations as we have no retained interest in these transactions. There was no variable rate residential mortgage loans securitization in 2004. Royal Bank of Canada Annual Report 2006 116 Consolidated Financial Statements The key assumptions used to value the retained interests at the date of the securitization activities are as follows: Key assumptions (1), (2) Expected weighted average life of prepayable receivables (in years) Payment rate Excess spread, net of credit losses Expected credit losses Discount rate 2006 Residential mortgage loans Variable rate Fixed rate 2.61 30.00% 1.18 – 4.32 3.60 15.39% .99 – 4.36 Credit card loans .16 40.02% 5.13 2.15 10.00 2005 Residential mortgage loans 2004 (3) Residential mortgage loans (4) Variable rate Fixed rate Fixed rate 3.48 13.52% .20 – 3.64 3.59 13.36% 1.06 – 3.59 3.88 12.00% .74 – 3.83 Credit card loans .15 40.06% 6.88 1.75 10.00 (1) (2) (3) (4) All rates are annualized except the payment rate for credit card loans which is monthly. This analysis is not applicable for commercial mortgage loans securitizations as we have no retained interest in these transactions. There was no credit card loans securitization in 2004. There was no variable rate residential mortgage loans securitization in 2004. 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, 2006 was .46%. Static credit pool losses are not applicable to residential mortgages as 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, 2006 and 2005: Loans managed Residential mortgage Personal Credit card Business and government Total loans managed (2) Less: Loans securitized and managed Credit card loans Mortgage-backed securities created and sold Mortgage-backed securities created and retained 2006 2005 Loan principal Past due (1) Net write-offs Loan principal Past due (1) Net write-offs $ $ 116,397 44,902 10,805 61,207 $ 308 235 65 531 233,311 1,139 3,650 14,131 5,591 – – – 5 310 248 30 593 85 – – $ $ 103,258 41,045 9,300 53,626 $ 302 216 61 499 207,229 1,078 3,100 9,561 2,654 – – – 5 279 240 118 642 46 – – Total loans reported on the Consolidated Balance Sheets $ 209,939 $ 1,139 $ 508 $ 191,914 $ 1,078 $ 596 (1) (2) Includes impaired loans as well as loans that are contractually 90 days past due but are not considered impaired. Excludes any assets we have temporarily acquired with the intent at acquisition to sell to SPEs. At October 31, 2006, key economic assumptions and the sensitivity of the current fair value of our retained interests to immediate 10% and 20% adverse changes in key assumptions are shown in the table below. 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 assumption to the change in fair value may not be linear. Sensitivity of key assumptions to adverse changes (1), (2) Also, the effect of a variation in a particular assumption on the fair value of the retained interests is calculated without changing any other assumption; generally, changes in one factor may result in changes in another, which may magnify or counteract the sensitivities. Credit card loans 2006 Residential mortgage loans Variable rate Fixed rate Fair value of retained interests Weighted average remaining service life (in years) Payment rate Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Excess spread, net of credit losses Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Expected credit losses Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Discount rate Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change $ $ 17.9 .25 36.55% (1.0) (2.0) $ $ 5.71% (1.8) (3.5) 1.87% (.6) (1.2) $ 14.2 .48–3.02 30.00–40.00% (.4) (.8) $ $ .80–.93% (1.0) (3.1) $ 211.0 3.06–3.85 10.00–18.00% $ (5.1) (10.2) .83–1.88% (21.2) $ (42.5) $ –% – – $ –% – – $ 10.00% – – 4.24–6.00% – $ (.1) 4.24–4.33% $ (2.3) (4.6) (1) (2) All rates are annualized except for the credit card loans payment rate which is monthly. This analysis is not applicable for commercial mortgage loans securitizations as we have no retained interest in these transactions. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 117 Note 6 Variable interest entities The following table provides information about VIEs as at October 31, 2006 and 2005, in which we have a significant variable interest and those that we consolidate under Accounting Guideline 15, Consolidation of Variable Interest Entities (AcG-15) because we are the Primary Beneficiary. Total assets as at Total assets as at October 31, 2006 October 31, 2006 October 31, 2005 Maximum exposure to loss at Maximum exposure to loss at October 31, 2005 Unconsolidated VIEs in which we have a significant variable interest (1) Multi-seller conduits (2) Third-party conduits Structured finance VIEs Investment funds Other Collateralized Debt Obligations Consolidated VIEs (3), (4) Investment funds Credit investment product VIEs Structured finance VIEs Compensation vehicles Other $ 34,258 2,697 2,592 3,390 128 – $ 35,031 1,018 1,465 303 84 – $ 29,253 2,162 1,907 6,634 915 1,104 $ 29,442 672 1,410 899 57 16 $ 43,065 $ 37,901 $ 41,975 $ 32,496 $ 1,851 689 409 355 151 $ 1,140 660 471 311 140 $ 3,455 $ 2,722 (1) (2) (3) (4) The maximum exposure to loss resulting from our significant variable interest in these VIEs consists mostly of investments, loans, liquidity facilities and fair value of derivatives. We have recognized $2,130 million (2005 – $2,628 million) of this exposure on our Consolidated Balance Sheets. Total assets represent maximum assets that may have to be purchased by the conduits under purchase commitments outstanding as at October 31, 2006. Actual assets held by these conduits as at October 31, 2006, were $24,811 million (2005 – $20,191 million). 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 $120 million (2005 – $152 million), Trading account securities of $2,483 million (2005 – $1,733 million), Investment account securities of $409 million (2005 – $406 million) and Other assets of $287 million (2005 – $246 million). The compensation vehicles hold $156 million (2005 – $185 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. 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 liquid- ity facilities or credit enhancement facilities to, or enter into derivative transactions with, the VIEs. Multi-seller and third-party conduits We administer six 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. During 2006, the multi-seller conduits also financed assets in the form of either securities 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 commensu- rate 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 are not required to 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 enhance- ment and our 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 are not required to 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 con- solidate structured finance VIEs in which our interests expose us to a majority of the expected losses. Collateralized Debt Obligations Through our Collateral Debt Obligation (CDO) management business, we acted as collateral manager for several CDO entities which invested in leveraged bank-initiated term loans, high yield bonds and mezzanine cor- porate loans. As part of our role, we were required to invest in a portion of the CDOs’ first-loss tranche. Our total exposure to loss was through fees we earned as a collateral manager and our share of the first-loss tranche. This exposure comprised less than a majority of the total expected losses of the CDOs and therefore, we were not the Primary Beneficiary. We sold our CDO management business in 2005 to a third party, excluding the first-loss tranche investments which were sold during 2006. Creation of credit investment products We use VIEs to generally transform credit derivatives into cash instru- ments, to distribute credit risk and to create customized credit products to meet investors’ specific requirements. We enter into derivative con- tracts 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 which do 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. Royal Bank of Canada Annual Report 2006 118 Consolidated Financial Statements Compensation vehicles We use compensation trusts, which primarily hold our own common shares, to economically hedge our obligation to certain employees under our stock-based compensation programs. We consolidate the trusts in which we are the Primary Beneficiary. Capital trusts RBC Capital Trust II (Trust II) was created in 2003 to issue $900 million innovative capital instruments. We issued a senior deposit note of the same amount to this trust. Although we own the common equity and voting control of the trust, 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 the trust. For details on our innovative capital instruments, refer to Note 17. Note 7 Derivative financial instruments 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 trans- acted between counterparties in the over-the-counter market, whereas futures are standardized contracts with respect to amounts and settle- ment dates, and are traded on regular 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 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 a fixed value (the contracted price) of an equity index, a basket of stocks or a single stock at a specified 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. 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 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 qualifying SPE under AcG-12, which is specifically exempt from consolidation under AcG-15, and our level of participation in each of the remaining third-party 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. 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 refer- enced 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 held or issued for trading purposes Most of our derivative transactions relate to sales and trading activi- ties. 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. We do Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 119 Note 7 Derivative financial instruments (continued) not deal, to any significant extent, in leveraged derivative transactions. These transactions contain a multiplier which, for any given change in market prices, could cause the change in the transactions’ fair values to be significantly different from the change in fair values that would occur for similar derivatives without the multiplier. Derivatives held or issued for other-than-trading purposes We also use derivatives in connection with our own asset/liability management activities, which include hedging 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. 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 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 Notional amount of derivatives by term to maturity either cause assets and liabilities to appreciate or depreciate in market value or cause variability in forecasted cash flows. When a derivative functions effectively as a hedge, gains, losses, revenue and expenses on the derivative will offset the gains, losses, revenue and expenses on the hedged item. We may also choose to 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. We did not apply hedge accounting to any anticipated transactions for the year ended October 31, 2006. Derivatives – Notional amounts Notional amounts, which are off-balance sheet, serve as a point of refer- ence for calculating payments and are a common measure of business volume. The following table provides the notional amounts of our deriv- ative transactions by term to maturity. Excluded from the table below are notional amounts of $121 million (2005 – $198 million), relating to certain warrants and loan commitments reported as derivatives. Over-the-counter contracts Interest rate contracts Forward rate agreements Swaps Options purchased Options written Foreign exchange contracts Forward contracts Cross currency swaps Cross currency interest rate swaps Options purchased Options written Credit derivatives (2) Other contracts (3) Exchange-traded contracts Interest rate contracts Futures – long positions Futures – short positions Options purchased Options written Foreign exchange contracts Futures – long positions Futures – short positions Other contracts (3) Term to maturity 2006 2005 Within 1 year 1 to 5 years Over 5 years (1) Total Trading Other than trading Trading Other than trading $ 302,435 812,548 34,122 28,878 $ 12,943 847,446 40,397 33,906 $ – 354,444 24,739 10,782 $ 315,378 2,014,438 99,258 73,566 $ 315,378 1,874,206 99,172 73,566 $ – 140,232 86 – $ 124,504 1,014,868 58,571 53,420 $ – 138,117 53 – 626,968 2,678 48,497 52,395 54,874 16,096 38,916 140,939 177,930 66,647 119,034 5,149 26,088 250,199 31,484 9,586 133,383 13,203 13,498 114,419 21,516 1,065 7,361 66,917 45 16 91,261 26,689 659,517 19,625 248,797 65,643 68,388 221,776 87,121 626,484 18,553 228,090 65,572 68,337 219,054 86,548 33,033 1,072 20,707 71 51 2,722 573 6,465 32,413 5,279 160 921 – 6,955 6 1,689 – – 147,410 212,032 71,926 119,194 146,886 211,131 71,926 119,194 – – – 6,070 26,088 257,154 6,070 26,088 257,154 524 901 – – – – – 518,109 15,565 175,417 100,710 111,322 169,412 77,993 74,440 110,874 83,926 38,028 9,785 2,230 76,894 33,128 407 10,389 23 16 3,843 216 644 1,208 – – – – – $ 2,804,393 $ 1,323,974 $ 585,014 $ 4,713,381 $ 4,513,409 $ 199,972 $ 2,816,068 $ 188,044 (1) (2) (3) Includes contracts maturing in over 10 years with a notional value of $135,951 million (2005 – $87,299 million). The related gross positive replacement cost is $3,857 million (2005 – $2,556 million). Comprises credit default swaps, total return swaps and credit default baskets, including credit derivatives given guarantee treatment for OSFI regulatory reporting purposes. Comprises precious metal, commodity and equity-linked derivative contracts other than embedded equity-linked contracts. Royal Bank of Canada Annual Report 2006 120 Consolidated Financial Statements The following table provides the fair value of our derivative financial instruments: Fair value of derivative instruments Held or issued for trading purposes Interest rate contracts Forward rate agreements Swaps Options purchased Options written Foreign exchange contracts Forward contracts Cross currency swaps Cross currency interest rate swaps Options purchased Options written 2006 2005 Average fair value for year ended (1) Year-end fair value Average fair value for year ended (1) Year-end fair value Positive Negative Positive Negative Positive Negative Positive Negative $ 52 12,150 795 – $ 50 12,003 – 888 $ 44 12,258 602 – $ 60 11,969 – 698 $ 26 15,898 713 – $ 11 15,655 – 749 $ 21 13,298 989 – $ 19 12,954 – 1,079 12,997 12,941 12,904 12,727 16,637 16,415 14,308 14,052 6,740 2,041 7,010 1,571 – 6,969 1,522 8,275 – 1,582 5,493 2,151 6,703 1,055 – 5,758 1,522 8,319 – 994 8,064 1,503 6,191 2,088 – 8,467 1,316 6,630 – 1,841 6,696 1,788 6,163 2,149 – 7,059 1,388 7,397 – 2,049 17,362 18,348 15,402 16,593 17,846 18,254 16,796 17,893 Credit derivatives (2) Other contracts (3) 1,139 5,623 975 8,803 1,795 5,798 1,580 9,221 992 2,888 873 6,732 914 5,605 908 8,398 $ 37,121 $ 41,067 $ 35,899 $ 40,121 $ 38,363 $ 42,274 $ 37,623 $ 41,251 Held or issued for other-than-trading purposes Interest rate contracts Swaps Options purchased Foreign exchange contracts Forward contracts Cross currency swaps Cross currency interest rate swaps Options purchased Options written Credit derivatives (2) Other contracts (3) Total gross fair values before netting Impact of master netting agreements With intent to settle net or simultaneously (4) Without intent to settle net or simultaneously (5) Total $ $ 1,100 – 1,100 102 5 607 1 – 715 20 85 940 – 940 236 5 631 – 1 873 30 281 1,920 2,124 37,819 42,245 (137) (18,952) (137) (18,952) $ 18,730 $ 23,156 $ $ 982 1 983 173 – 423 – – 596 20 45 937 – 937 221 56 365 – – 642 20 111 1,644 1,710 39,267 42,961 (144) (20,822) (144) (20,822) $ 18,301 $ 21,995 (1) (2) (3) (4) (5) Average fair value amounts are calculated based on monthly balances. Comprises credit default swaps, total return swaps and credit default baskets, including credit derivatives given guaranteed treatment for OSFI regulatory reporting purposes. Comprises precious metal, commodity and equity-linked derivative contracts. Certain warrants and loan commitments that meet the definition of derivatives are also included. 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. 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. 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, diversi- fication 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. A master netting agreement provides for a single net settle- ment of all financial instruments covered by the agreement in the event of default on, or termination of, any one contract. However, credit risk is eliminated only to the extent that our financial obligations to the same counterparty can be settled after we have realized contracts with a favourable position. 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 Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 121 Note 7 Derivative financial instruments (continued) the use of master netting agreements to reduce derivative-related credit exposure. Our overall exposure to credit risk reduced through master netting agreements may change substantially following the reporting date as the exposure is affected by each transaction sub- ject to the agreements as well as changes in underlying market rates. However, measurement of our credit exposure arising out of derivative transactions is not reduced to reflect the effects of netting unless the enforceability of that netting is supported by appropriate legal analysis, as documented in our policy. To further manage derivative-related counterparty credit exposure, we include mark-to-market provisions, typically in the form of a Credit Support Annex, in our agreements with some counterparties. Under such provisions, we have the right to request that the counterparty pay down or collateralize the current market value of its derivatives position with us when the position passes a specified threshold. The use of collateral is another significant credit mitigation technique for managing derivative-related counterparty credit risk with other banks and broker-dealers. The tables below show replacement cost, credit equivalent and risk-adjusted amounts of our derivatives both before and after the impact of netting. During 2006, 2005 and 2004, neither our actual credit losses arising from derivative transactions nor the level of impaired derivative contracts were significant. 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 $734 million (2005 – $504 million) relating to exchange-traded instru- ments as they are subject to daily margining and are deemed to have no credit risk. Fair value of $nil (2005 – $1 million) relating to certain warrants and loan commitments that meet the definition of derivatives for financial reporting purposes is also excluded. The credit equivalent amount is defined as the sum of the replace- ment cost plus an add-on amount for potential future credit exposure as defined by the OSFI. The risk-adjusted amount is determined by applying standard OSFI defined measures of counterparty risk to the credit equivalent amount. Derivative-related credit risk Interest rate contracts Forward rate agreements Swaps Options purchased Foreign exchange contracts Forward contracts Swaps Options purchased Credit derivatives (1) Other contracts (2) 2006 2005 Replacement cost Credit equivalent amount Risk-adjusted balance Replacement cost Credit equivalent amount Risk-adjusted balance $ 44 $ 13,358 591 109 21,031 1,164 13,993 22,304 5,595 9,466 1,056 12,413 22,697 2,244 16,117 37,354 1,795 5,160 6,975 8,696 $ 22 4,452 260 4,734 3,310 4,305 502 8,117 2,009 2,760 $ 21 14,280 958 $ 44 19,496 1,182 $ 15,259 20,722 6,869 8,374 2,149 12,389 18,935 3,625 17,392 34,949 914 5,177 4,663 8,670 10 4,742 338 5,090 3,408 3,744 971 8,123 1,453 2,886 Derivatives before master netting agreements Impact of master netting agreements $ 37,065 (19,089) $ 75,329 (31,831) $ 17,620 (7,188) $ 38,742 (20,966) $ 69,004 (31,182) $ 17,552 (7,856) Total derivatives after master netting agreement $ 17,976 $ 43,498 $ 10,432 $ 17,776 $ 37,822 $ 9,696 (1) (2) Comprises credit default swaps, total return swaps and credit default baskets. Credit derivatives classified as “other-than-trading” with a replacement cost of $20 million (2005 – $20 million), credit equivalent amount of $283 million (2005 – $390 million) and risk-adjusted asset amount of $283 million (2005 – $390 million), which are given guarantee treatment per the OSFI guidance, are excluded from this table. Comprises precious metal, commodity and equity-linked derivative contracts. Replacement cost of derivative financial instruments by risk rating and by counterparty type Risk rating (1) Counterparty type (2) As at October 31, 2006 AAA, AA A BBB BB or lower Total OECD Banks governments Other Total Gross positive replacement cost Impact of master netting agreements $ 21,139 $ (12,566) 9,666 $ (4,273) 4,053 $ (1,783) 2,227 $ (467) 37,085 $ (19,089) 21,693 $ (16,015) 5,891 $ – 9,501 $ (3,074) 37,085 (19,089) Replacement cost (after netting agreements) (3) $ 8,573 $ 5,393 $ 2,270 $ 1,760 $ 17,996 $ 5,678 $ 5,891 $ 6,427 $ 17,996 Replacement cost (after netting agreements) – 2005 (3) $ 8,149 $ 4,943 $ 2,174 $ 2,530 $ 17,796 $ 6,631 $ 5,273 $ 5,892 $ 17,796 (1) (2) (3) 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. Counterparty type is defined in accordance with the capital adequacy requirements of the OSFI. Includes credit derivatives classified as “other than trading” with a total replacement cost of $20 million (2005 – $20 million). Royal Bank of Canada Annual Report 2006 122 Consolidated Financial Statements Note 8 Premises and equipment Land Buildings Computer equipment Furniture, fixtures and other equipment Leasehold improvements 2006 Accumulated depreciation $ $ – 321 1,698 736 673 $ Cost 134 511 2,462 1,012 1,127 $ Net book value 134 190 764 276 454 Cost 143 591 2,184 996 956 2005 Accumulated depreciation $ $ – 312 1,502 720 628 Net book value 143 279 682 276 328 $ 5,246 $ 3,428 $ 1,818 $ 4,870 $ 3,162 $ 1,708 The depreciation expense for premises and equipment for 2006 was $405 million (2005 – $414 million; 2004 – $387 million). Note 9 RBC Dexia Investor Services joint venture On January 2, 2006, we combined our Institutional & Investor Services business (IIS), previously operated mainly through our wholly-owned subsidiaries Royal Trust Corporation of Canada, The Royal Trust Company, and RBC Global Services Australia Pty Limited, with the Dexia Funds Services business of Dexia Banque Internationale à Luxembourg (Dexia) in return for a 50% joint venture interest in a newly formed company known as RBC Dexia Investor Services (RBC Dexia IS). Under the agreement with Dexia, we contributed net assets with a carrying value of approximately $895 million, of which $84 million was related to IIS goodwill. We did not recognize a gain or loss on this transaction. RBC Dexia IS, which provides an integrated suite of institutional investor products and services, including global custody, fund and pen- sion administration, securities lending, shareholder services, analytics and other related services to institutional investors worldwide, is a hold- ing company headquartered in London, United Kingdom. Operations of RBC Dexia IS are conducted mainly through RBC Dexia Investor Services Trust in Canada and RBC Dexia Investor Services Bank in Luxembourg and their respective subsidiaries and branches around the world. We report the results of RBC Dexia IS on a one-month lag basis. For our year ended October 31, 2006, we have included our proportion- ate share of RBC Dexia IS financial results for their nine months ended September 30, 2006. 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: Consolidated Statements of Income Net interest income Non-interest income Non-interest expense Net income Consolidated Statements of Cash Flows Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities For the nine months ended October 31, 2006 (1) $ $ 75 363 315 73 (71) (97) 165 (1) Represents our proportionate share of RBC Dexia IS financial results for their nine months ended September 30, 2006. Along with Dexia, we provide certain operational services to RBC Dexia IS, which include administrative and technology support, human resources and others. In addition, both Dexia and we provide, on an equal basis, credit and banking facilities to RBC Dexia IS to support its operations. RBC Dexia IS provides certain services to Dexia and 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 amounts of interest income earned and expenses incurred by RBC Dexia IS related to transactions with RBC are as follows: Consolidated Balance Sheets Assets (1) Liabilities As at October 31, 2006 $ 12,354 11,396 (1) Includes $69 million of goodwill and $208 million of intangible assets. Net interest income Non-interest income Non-interest expense For the nine months ended October 31, 2006 $ 99 16 28 Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 123 Note 10 Goodwill and other intangibles We have completed the annual test for goodwill impairment in all report- ing units and have determined that goodwill is not impaired. The following table discloses the changes in goodwill over 2006 and 2005: Goodwill Balance at October 31, 2004 Other adjustments (1) Balance at October 31, 2005 Goodwill acquired during the year Other adjustments (2), (3) Balance at October 31, 2006 RBC Canadian Personal and Business RBC U.S. and International Personal and Business RBC Capital Markets $ $ $ $ 2,502 (83) 2,419 – 72 $ $ 792 39 831 86 (17) $ $ 986 (33) 953 – (40) Total 4,280 (77) 4,203 86 15 $ 2,491 $ 900 $ 913 $ 4,304 (1) (2) (3) Other adjustments in 2005 primarily include changes to RBC Dain Rauscher’s goodwill due to resolutions of pre-acquisition tax positions, reclassification of certain trust businesses’ intangibles to goodwill, and the impact of foreign exchange translations on non-Canadian dollar-denominated goodwill. Other adjustments in 2006 primarily include the impact of foreign exchange translations on non-Canadian dollar-denominated goodwill, changes in goodwill related to our IIS business with RBC Dexia IS (refer to Note 9), and the transfer of $6 million housing tax credit syndication business goodwill from RBC U.S. and International Personal and Business to RBC Capital Markets. Refer to Note 30. During 2006, we adjusted the foreign exchange translation of certain non-Canadian dollar-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 gain (loss) on our Consolidated Statements of Changes in Shareholders’ Equity. Other intangibles Core deposit intangibles Customer lists and relationships (2) Mortgage servicing rights 2006 2005 Gross carrying amount Accumulated amortization (1) Net carrying amount Gross carrying amount Accumulated amortization (1) Net carrying amount $ $ 324 625 44 993 $ (163) $ (156) (32) $ (351) $ 161 469 12 642 $ $ 346 275 68 689 $ (149) $ (105) (26) $ (280) $ 197 170 42 409 (1) (2) Total amortization expense for 2006 was $76 million (2005 – $50 million; 2004 – $69 million). Increase primarily relates to our joint venture investment in RBC Dexia IS and acquisitions made in 2006. Refer to Note 9 and Note 11, respectively. During 2005, we revisited the goodwill and intangible assets identified in connection with the acquisition of certain trust businesses in fiscal 1999 and 2000 and determined that approximately $57 million (€28 million) initially allocated to customer lists and relationships actually represented goodwill. The reallocation resulted in an increase in the carrying amount of goodwill and a recovery of approximately $15 million of amortization expense given that we ceased amortizing goodwill and indefinite life intangibles beyond November 1, 2001, in accordance with GAAP. The projected amortization of Other intangibles for each of the years ending October 31, 2007 to October 31, 2011 is approximately $77 million. There were no writedowns of intangible assets due to impair- ment for the year ended October 31, 2006 (2005 – nil; 2004 – nil). Note 11 Significant acquisitions and dispositions 2006 Acquisitions 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. Acquisition date Business segment Percentage of shares acquired Purchase consideration Fair value of tangible assets acquired Fair value of liabilities assumed Fair value of identifiable net tangible assets acquired Customer lists and relationships (2) Goodwill Total purchase consideration 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 American Guaranty & Trust November 30, 2005 October 3, 2006 RBC U.S. and International Personal and Business RBC U.S. and International Personal and Business 100% 100% Cash payment of £105(1) Cash payment of US$12.5 $ $ 43 (23) 20 116 77 213 $ 3 – 3 2 9 $ 14 (1) (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. Customer lists and relationships are amortized on a straight-line basis over an estimated average useful life of 15 years. Royal Bank of Canada Annual Report 2006 124 Consolidated Financial Statements Pending acquisitions On August 9, 2006, RBC Centura Banks, Inc. announced the signing of a definitive merger agreement pursuant to which RBC Centura Banks, Inc. will acquire Atlanta, Georgia-based Flag Financial Corporation (Flag) and its subsidiary, Flag Bank. Under the agreement, shareholders of Flag will receive US$25.50 per share for a total purchase price of approxi- mately US$456 million. The acquisition is subject to customary closing conditions, including approval by U.S. and Canadian regulators. This transaction is expected to be completed by the end of calendar year 2006. On October 25, 2006, RBC Capital Markets announced that it has agreed to acquire the broker-dealer business and certain other assets of the Carlin Financial Group, a New York-based boutique broker- dealer. This transaction is subject to regulatory approval and other customary closing conditions and is expected to be completed in the first quarter of 2007. 2005 Disposition On December 31, 2004, we completed the sale of our subsidiary Liberty Insurance Services Corporation to IBM Corporation for cash. The nominal gain on the sale was reported in RBC Canadian Personal and Business. Discontinued operations 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 has substantially disposed of its remaining assets and obligations that were not transferred to Home123. These are recorded separately on the Consolidated Balance Sheets as Assets of operations held for sale and Liabilities of operations held for sale. The operating results of RBC Mortgage are classified as discontinued operations for all periods presented in the Consolidated Statements of Income. RBC Mortgage’s business realignment charges (refer to Note 23) have been reclassified to discontinued operations. 2004 Acquisitions During 2004, we completed the acquisitions of Provident Financial Group Inc.’s Florida banking operations (Provident), William R. Hough & Co., Inc. (William R. Hough) and the Canadian operations of Provident Life and Accident Insurance Company (UnumProvident). The details of these acquisitions are as follows: Acquisition date Business segment Percentage of shares acquired Purchase consideration Fair value of tangible assets acquired Fair value of liabilities assumed Fair value of identifiable net tangible assets acquired Core deposit intangibles (1) Customer lists and relationships (1) Goodwill Total purchase consideration Provident William R. Hough November 21, 2003 February 27, 2004 UnumProvident May 1, 2004 RBC U.S. and International Personal and Business RBC Capital Markets RBC Canadian Personal and Business n.a. 100% Cash payment of US$81 Cash payment of US$112 $ 1,145 (1,180) (35) 13 – 127 $ 105 $ $ 54 (21) 33 – 12 105 150 n.a. n.a. (2) $ 1,617 (1,617) – – – – – $ (1) (2) Core deposit intangibles and customer lists and relationships are amortized on a straight-line basis over an estimated average useful life of 8 and 15 years, respectively. In connection with the acquisition of the Canadian operations of UnumProvident, we assumed UnumProvident’s policy liabilities and received assets with the equivalent fair value to support future payments. Note 12 Other assets Receivable from brokers, dealers and clients Accrued interest receivable Investment in associated corporations and limited partnerships Insurance-related assets (1) Net future income tax asset (refer to Note 24) Prepaid pension benefit cost (2) (refer to Note 20) Cheques and other items in transit Other $ $ 2006 3,172 2,229 1,614 702 1,104 761 489 5,346 2005 1,934 1,716 1,423 679 1,248 540 2,117 3,251 $ 15,417 $ 12,908 (1) (2) 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. Prepaid pension benefit cost represents the cumulative excess of pension fund contributions over pension benefit expense. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 125 Note 13 Deposits The following table details our deposit liabilities as at October 31, 2006 and 2005. Personal Business and government (4) Bank Non-interest bearing Canada United States Other International Interest-bearing Canada (4) United States Other International Demand (1) Notice (2) Term (3) Total 2006 2005 Total $ 13,805 58,444 6,380 $ 32,969 15,158 128 $ 67,266 115,538 33,835 $ 114,040 189,140 40,343 $ 111,618 160,593 34,649 $ 78,629 $ 48,255 $ 216,639 $ 343,523 $ 306,860 $ 19,088 2,293 1,241 $ 17,729 3,799 908 174,170 50,123 96,608 167,243 41,399 75,782 $ 343,523 $ 306,860 (1) (2) (3) (4) 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. Deposits payable after notice include all deposits for which we can legally require notice of withdrawal. These deposits are primarily savings accounts. Term deposits include deposits payable on a fixed date. These deposits include term deposits, guaranteed investment certificates and similar instruments. At October 31, 2006, the balance of term deposits also includes senior deposit notes we have issued to provide long-term funding of $33.4 billion (2005 – $24.0 billion) and other notes and similar instruments in bearer form of $30.2 billion (2005 – $24.9 billion). 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 exchange right. Refer to Note 17 for more information on RBC TruCS 2013. The contractual maturities of the term deposits are as follows: Term deposits (1) Within 1 year 1 to 2 years 2 to 3 years 3 to 4 years 4 to 5 years Over 5 years Total 2006 $ 167,252 21,907 7,716 6,170 9,145 4,449 $ 216,639 (1) The aggregate amount of term deposits in denominations of $100,000 or more as at October 31, 2006 was $175 billion. The following table presents the average deposit balances and average rate of interest paid during 2006 and 2005: Average deposit balances and rates Canada United States Other International Average balances 2006 2005 $ 183,085 48,272 91,942 $ 176,665 40,497 71,035 $ 323,299 $ 288,197 Average rate 2006 2.74% 4.18 3.99 3.31% 2005 2.11% 2.59 3.06 2.41% Royal Bank of Canada Annual Report 2006 126 Consolidated Financial Statements Note 14 Insurance Insurance claims and policy benefit liabilities Life and health Property and casualty Reinsurance Total Future policy benefit liabilities Claims liabilities Total 2006 6,655 386 296 7,337 6,605 732 $ $ $ 2005 6,414 316 387 7,117 6,360 757 7,337 $ 7,117 $ $ $ $ The increase in Insurance claims and policy benefit liabilities over the prior year is comprised of a net increase in life and health and property and casualty reserves attributable to business growth, and a net decrease in our reinsurance reserves reflecting claim payments related to hurricanes Katrina, Rita and Wilma. Furthermore, as a result of a review of various actuarial assump- tions and the completion of certain actuarial experience studies, we recorded a net decrease of $15 million of life and health insurance reserves. All changes collectively resulted in a $75 million net decrease in health reserve, largely offset by a net increase in life and annuity reserves of $60 million. This was predominantly driven by the impact of changes to interest rate assumptions which shifted the liability by line of business, investment portfolio changes, decreases in long-term interest rates, the introduction of the new actuarial standard of practice for interest rates and other minor assumption changes. The changes in the insurance claims and policy benefit liabilities are included in Insurance policyholder benefits, claims and acquisition expense in the Consolidated Statements 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 pro- vide 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 insur- ance 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 included in Non-interest income for the years ended October 31 are shown in the table below: Net premiums Gross premiums Ceded premiums Note 15 Other liabilities Short-term borrowings of subsidiaries Payable to brokers, dealers and clients Accrued interest payable Accrued pension and other post-employment benefit expense (1) (refer to Note 20) Insurance-related liabilities Dividends payable Other 2006 3,405 (810) $ 2005 3,329 (765) $ 2004 2,956 (574) 2,595 $ 2,564 $ 2,382 $ $ $ 2006 $ 3,929 3,382 2,556 1,250 491 526 10,515 2005 3,309 3,161 1,827 1,195 485 424 8,007 $ 22,649 $ 18,408 (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 2006 Consolidated Financial Statements 127 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 deben- tures are subject to the consent and approval of the OSFI. On August 25, 2006, we announced our intention to redeem all of our outstanding US$400 million subordinated debentures due November 8, 2011 at par value plus accrued interest. The redemption was completed on November 8, 2006. Maturity March 15, 2009 February 13, 2011 April 26, 2011 September 12, 2011 October 24, 2011 November 8, 2011 June 4, 2012 January 22, 2013 January 27, 2014 June 1, 2014 November 14, 2014 January 25, 2015 June 24, 2015 April 12, 2016 November 4, 2018 June 8, 2023 October 1, 2083 June 6, 2085 June 18, 2103 Earliest par value redemption date February 13, 2006 April 26, 2006 September 12, 2006 October 24, 2006 November 8, 2006 June 4, 2007 January 22, 2008 January 27, 2009 June 1, 2009 (1) (1) (1) (1) (2) (4) (6) (7) (8) January 25, 2010 (9) June 24, 2010 (7) April 12, 2011 (10) November 4, 2013 (11) Interest rate 6.50% 5.50% 8.20% 6.50% 6.75% 6.75% 6.10% 3.96% 4.18% 10.00% 7.10% 3.70% 6.30% 5.45% 9.30% (3) (5) (5) (5) (5) (5) (5) (5) (5) Denominated in foreign currency 2006 US$125 $ US$300 US$400 $ 140 – – – – 449 483 497 493 997 200 495 791 400 985 110 224 239 600 2005 148 124 99 350 345 473 500 500 498 1,000 200 500 800 400 1,000 110 246 274 600 (12) (12) June 18, 2009 (15) (13) (14) 5.95% (16) US$213 $ 7,103 $ 8,167 (10) 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. (11) 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. (12) Redeemable on any interest payment date at par value. (13) Interest at a rate of 40 basis points above the 30-day Bankers’ Acceptance rate. (14) 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. (15) 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 value and the yield on a non-callable Government of Canada bond plus .21% if redeemed prior to June 18, 2014, or .43% if redeemed at any time after June 18, 2014. (16) Interest at a rate of 5.95% until the earliest par value redemption date and every 5 years thereafter at the 5-year Government of Canada bond yield plus 1.72%. The terms and conditions of the debentures are as follows: (1) Redeemed on the earliest par value redemption date at par value. (2) Redeemable on the earliest par value redemption date at par value. (3) Interest at a rate of 50 basis points above the U.S. dollar 3-month LIBOR until earliest par value redemption date, and thereafter at a rate of 1.50% above the U.S. dollar 3-month LIBOR. (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 5 basis points and (ii) par value, and thereafter at any time at par value. 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. (5) (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 18 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 8 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 9 basis points and (ii) par value, and thereafter at any time at par value. (9) 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. Maturity schedule The aggregate maturities of subordinated debentures, based on the maturity dates under the terms of issue, are as follows: At October 31, 2006 1 to 5 years 5 to 10 years Thereafter Royal Bank of Canada Annual Report 2006 128 Consolidated Financial Statements Total $ 140 4,789 2,174 $ 7,103 Note 17 Trust capital securities We issue innovative capital instruments, RBC Trust Capital Securities (TruCS), through two SPEs: RBC Capital Trust (Trust) and RBC Capital Trust II (Trust II). In prior years, we issued non-voting RBC Trust Capital Securities Series 2010 and 2011 (RBC TruCS 2010 and 2011) through our consoli- dated subsidiary RBC Capital Trust, a closed-end trust established under the laws of the Province of Ontario. RBC TruCS 2010 and 2011 are classi- fied 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. In 2005, we issued another series of non-voting trust capital securi- ties, RBC Trust Capital Securities Series 2015 (RBC TruCS 2015), through the Trust. Unlike the RBC TruCS 2010 and 2011, the holders of these instruments 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 our outstanding TruCS as at October 31, 2006 and 2005: Issuer Issuance date Distribution dates Redemption date Conversion date Annual yield At the option of the issuer At the option of the holder 2006 Principal amount 2005 Principal amount RBC Capital Trust (1), (2), (3), (4), (5), (6), (7) Included in Trust capital securities 650,000 Trust Capital Securities – Series 2010 750,000 Trust Capital Securities – Series 2011 Included in Non-controlling interest in subsidiaries 1,200,000 Trust Capital Securities – Series 2015 RBC Capital Trust II (2), (3), (4), (5), (6), (7), (9) 900,000 Trust Capital Securities – Series 2013 July 24, 2000 June 30, December 31 7.288% December 31, 2005 December 31, 2010 December 6, 2000 June 30, December 31 7.183% December 31, 2005 December 31, 2011 $ $ 650 750 $ $ 650 750 $ 1,400 $ 1,400 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 July 23, 2003 June 30, December 31 5.812% December 31, 2008 Any time $ 900 $ 900 The significant terms and conditions of the TruCS 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) 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 redemp- tion occurs on or after December 31, 2013 and 2015, respectively. 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. (4) Each RBC TruCS 2010, 2011, 2013 and 2015 will be exchanged automat- ically without the consent of the holders for 40 of our non-cumulative redeemable First Preferred Shares Series Q, R, T and Z, respectively, upon occurrence of any one of the following events: (i) proceedings are commenced for the winding-up of the bank; (ii) the OSFI takes control of the bank; (iii) the bank has Tier 1 capital ratio of less than 5% or Total capital ratio of less than 8%; or (iv) the OSFI has directed the bank to increase its capital or provide additional liquidity and the bank elects such automatic exchange or the bank fails 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 instru- ments and hold them on a temporary basis. As at October 31, 2006, we held $17 million of RBC TruCS 2011 (2005 – $nil), $12 million of RBC TruCS 2015 (2005 – $nil) and $nil of RBC TruCS 2013 (2005 – $2 million) as treasury holdings which were deducted from regulatory capital. (6) According to the OSFI guidelines, innovative capital instruments can comprise up to 15% of net Tier 1 capital with an additional 3% eligible for Tier 2B capital. Any amount in excess of the 18% limitation is not recognized for regulatory capital purposes. As at October 31, 2006, $3,222 million (2005 – $2,835 million) represents Tier 1 capital, $249 million (2005 – $567 million) represents Tier 2B capital and $29 million (2005 – $2 million) of our treasury holdings of innovative capital is deducted for regulatory capital purposes. As at October 31, 2006, none of our innovative capital instruments exceeds the OSFI’s limit of 18% (2005 – $96 million). (7) 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 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 the 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. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 129 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. Issued and outstanding shares (1) Common – An unlimited number of shares without nominal or par value may be issued. Number of shares (000s) 2006 Amount Dividends declared per share Number of shares (000s) 2005 Amount Dividends declared per share Number of shares (000s) 2004 Amount Dividends declared per share Preferred share liabilities First preferred Non-cumulative Series N Treasury shares – purchases (2) 12,000 $ (84) 300 $ (2) 1.18 12,000 $ – 300 $ – 1.18 12,000 $ – 300 $ – 1.18 Preferred share liabilities, net of treasury holdings 11,916 $ 298 12,000 $ 300 12,000 $ 300 Preferred shares First preferred Non-cumulative Series O US$ Non-cumulative Series P (3) Non-cumulative Series S (4) Non-cumulative Series W (5) Non-cumulative Series AA (6) Non-cumulative Series AB (7) Common shares Balance at beginning of year Issued under the stock option plan (8) Purchased for cancellation 6,000 $ – – 12,000 12,000 12,000 150 $ – – 300 300 300 1.38 – 1.33 1.23 .71 .41 6,000 $ – 10,000 12,000 – – 150 $ – 250 300 – – 1.38 US 1.26 1.53 .99 – – 6,000 $ 4,000 10,000 – – – 150 $ 132 250 – – – 1.38 US 1.44 1.53 – – – $ 1,050 $ 700 $ 532 1,293,502 $ 5,617 (18,229) 7,170 127 (101) 1,289,496 $ 9,917 (5,911) 6,988 214 (32) 1,312,042 $ 6,657 (29,203) 7,018 127 (157) Balance at end of year 1,280,890 $ 7,196 $ 1.44 1,293,502 $ 7,170 $ 1.18 1,289,496 $ 6,988 $ 1.01 Treasury shares – Preferred shares Balance at beginning of year Sales Purchases Balance at end of year Treasury shares – Common shares Balance at beginning of year Sales Purchases Initial adoption of AcG-15 Reclassified amounts Balance at end of year (91) $ 2,082 (2,085) (94) $ (7,053) $ 5,097 (3,530) – – (5,486) $ (2) 51 (51) (2) (216) 193 (157) – – (180) – $ – (91) (91) $ (9,726) $ 5,904 (1,326) (1,905) – (7,053) $ – – (2) (2) (294) 179 (47) (54) – (216) – $ – – – $ – $ 7,550 (7,376) – (9,900) (9,726) $ – – – – – 248 (238) – (304) (294) (1) (2) (3) (4) (5) (6) (7) (8) On April 6, 2006, we paid a stock dividend of one common share on each of our issued and outstanding common shares. The effect is the same as a two-for-one share split. We have retroactively adjusted the number of common shares and dividends declared per share for the stock dividend. There was no sale of Preferred share liabilities – First preferred treasury shares during 2006, 2005 and 2004. On October 7, 2005, we redeemed Non-cumulative First Preferred Shares Series P. On October 6, 2006, we redeemed Non-cumulative First Preferred Shares Series S. The excess of the redemption price over the carrying value of $10 million was charged to Retained earnings in Preferred share dividends. On January 31, 2005, we issued 12 million Non-cumulative First Preferred Shares Series W at $25 per share. On April 4, 2006, we issued 12 million Non-cumulative First Preferred Shares Series AA at $25 per share. On July 20, 2006, we issued 12 million Non-cumulative First Preferred Shares Series AB at $25 per share. 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 $8 million (2005 – $10 million; 2004 – $5 million) and from renounced tandem SARs, net of related income taxes, of $2 million (2005 – $7 million; 2004 – $3 million). Terms of preferred share liabilities and preferred shares Preferred share liabilities First preferred Non-cumulative Series N Preferred shares First preferred Non-cumulative Series O Non-cumulative Series W Non-cumulative Series AA Non-cumulative Series AB Dividend per share (1) Redemption date (2) Redemption price (2), (3) At the option of the bank (2), (4) At the option of the holder (5) Conversion date $ $ .293750 August 24, 2003 .343750 .306250 .278125 .293750 August 24, 2004 February 24, 2010 May 24, 2011 August 24, 2011 $ $ 25.25 August 24, 2003 August 24, 2008 25.50 26.00 26.00 26.00 August 24, 2004 February 24, 2010 Not convertible Not convertible Not convertible Not convertible Not convertible Not convertible (1) Non-cumulative preferential dividends on Series N, O, W, AA and AB 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, 2006 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 O, at a price per share of $26, if redeemed during the 12 months commencing August 24, 2004, and decreasing by $.25 each 12-month period thereafter to a price per share of $25 if redeemed on or after August 24, 2008; 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 Royal Bank of Canada Annual Report 2006 130 Consolidated Financial Statements 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. (3) Subject to the consent of the OSFI and the requirements of the Act, we may purchase First Preferred Shares Series N, O, W, AA and AB for cancel- lation 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, O and W into our common shares. First Preferred Shares may be con- verted 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 fiscal quarter, (i) we report a cumulative consolidated net loss for the immediately preceding four quarters; and (ii) during the immediately preceding fiscal 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 (mature 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 are risk-adjusted capital ratios based on standards issued by the Bank for International Settlements 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 7% and a Total capital ratio of 10%. At October 31, 2006, our Tier 1 and Total capital ratios were 9.6% and 11.9%, respectively (2005 – 9.6% and 13.1%, respectively). At October 31, 2006, our assets-to-capital multiple was 19.7 times (2005 – 17.6 times), which remains below the maximum permitted by the OSFI. Dividend reinvestment plan Our dividend reinvestment 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 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 issue As at October 31, 2006, 42.2 million common shares are available for future issue relating to our dividend reinvestment plan and potential exercise of stock options outstanding. Other On October 19, 2006, we announced our intention to redeem all of our issued and outstanding 6 million Non-cumulative First Preferred Shares Series O at $25.50 per share including a $.50 redemption premium. The redemption was completed on November 24, 2006. We also announced on October 23, 2006, our intention to issue 8 million Non-cumulative First Preferred Shares Series AC at $25 per share, for total proceeds of $200 million. This issuance was completed on November 1, 2006. Normal course issuer bid Details of common shares repurchased under normal course issuer bids (NCIB) during 2006, 2005 and 2004 are given below. NCIB period June 26, 2006 – October 31, 2006 June 24, 2005 – June 23, 2006 NCIB period June 24, 2005 – June 23, 2006 June 24, 2004 – June 23, 2005 June 24, 2003 – June 23, 2004 Pre-stock dividend Post-stock dividend Total 2006 Number of shares eligible for repurchase (000s) Number of shares repurchased (000s) Average cost per share Number of shares repurchased (000s) Average cost per share Amount Amount 7,000 10,000 – 4,387 $ – 90.48 4,387 $ 90.48 $ $ – 397 397 6,595 2,859 $ 47.12 47.52 9,454 $ 47.24 $ $ 311 136 447 $ $ 311 533 844 Number of shares eligible for repurchase (000s) Number of shares repurchased (000s) 2005 (1) Average cost per share 10,000 25,000 25,000 1,950 1,005 – $ 83.50 63.24 – Number of shares repurchased (000s) 2004 (1) Average cost per share – 6,412 8,189 $ – 60.56 61.54 $ Amount 163 63 – $ Amount – 388 504 2,955 $ 76.61 $ 226 14,601 $ 61.11 $ 892 (1) The 2005 and 2004 number of shares and average cost per share are pre-stock dividend. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 131 Note 19 Non-controlling interest in subsidiaries RBC Trust Capital Securities Series 2015 Consolidated VIEs Others $ 2006 1,207 506 62 $ 2005 1,200 703 41 $ 1,775 $ 1,944 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. Refer to Note 17. As at October 31, 2006, $19 million (2005 – nil) of accrued interest net of $12 million (2005 – nil) of treasury holdings was included in RBC Trust Capital Securities Series 2015. 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, disabil- ity and life insurance coverage. During the year, we announced changes to our post-retirement benefit program in Canada which will be effective for eligible employees who retire on or after January 1, 2010. The new post-retirement program provides for the allotment of a fixed annual credit to eligible retirees which will be calculated based on the number of years of eligible service provided. The credit can be used toward the purchase of health and dental coverage after retirement. As a result of these changes, our ben- efit obligations have been reduced by $505 million. Plan assets, benefit obligation and funded status We fund our registered defined benefit pension plans in accordance with actuarially determined amounts required to satisfy employee ben- efit entitlements under current pension regulations. For our principal pension plans, the most recent actuarial valuation performed for funding purposes was completed on January 1, 2006. The next actuarial valua- tion for funding purposes will be completed on January 1, 2007. For 2006, our total contributions to pension and other post- employment benefit plans were $594 million and $58 million (2005 – $248 million and $56 million), respectively. For 2007, total con- tributions to defined benefit pension plans and other post-employment benefit plans are expected to be approximately $160 million and $60 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 our pension and other post-employment plans: Change in fair value of plan assets Opening fair value of plan assets Actual return on plan assets Company contributions Plan participant contributions Benefits paid Business acquisitions Other Change in foreign currency exchange rate Closing fair value of plan assets Change in benefit obligation Opening benefit obligation Service cost Interest cost Plan participant contributions Actuarial loss Benefits paid Plan amendments and curtailments Business acquisitions Other Change in foreign currency exchange rate Closing benefit obligation Funded status Excess of benefit obligation over plan assets Unrecognized net actuarial loss Unrecognized transitional (asset) obligation Unrecognized prior service cost Contributions between September 30 and October 31 Prepaid asset (accrued liability) as at October 31 Amounts recognized in the Consolidated Balance Sheets consist of: Other assets Other liabilities Net amount recognized as at October 31 Weighted average assumptions to calculate benefit obligation Discount rate Rate of increase in future compensation $ $ $ $ $ $ $ $ Pension plans (1) 2006 2005 Other post-employment plans (2) 2005 2006 5,719 445 518 24 (323) 21 2 1 6,407 6,524 173 345 24 38 (323) 24 31 5 (3) 6,838 (431) 963 (12) 131 14 665 761 (96) 665 $ $ $ $ $ $ $ $ 5,067 751 179 24 (295) – 18 (25) 5,719 5,503 138 344 24 798 (295) 1 – 49 (38) 6,524 (805) 1,127 (14) 136 3 447 540 (93) 447 $ $ $ $ $ $ $ $ 5.25% 4.40% 5.25% 4.40% $ $ $ $ $ $ $ $ 29 3 59 6 (56) – – – 41 1,891 26 77 6 38 (56) (515) 5 – (4) 1,468 (1,427) 598 (330) 1 4 (1,154) – (1,154) (1,154) 5.26% 4.40% 31 4 55 3 (64) – – – 29 1,620 49 101 3 180 (64) (1) – 6 (3) 1,891 (1,862) 604 140 11 5 (1,102) – (1,102) (1,102) 5.41% 4.40% (1) (2) For pension plans with funding deficits, the benefit obligations and fair values of plan assets totalled $6,156 million (2005 – $5,872 million) and $5,665 million (2005 – $5,026 million), respectively. 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 7.8% for medical decreasing to an ultimate rate of 4.9% in 2015 and 4.5% for dental. Royal Bank of Canada Annual Report 2006 132 Consolidated Financial Statements Benefit payment projection The following table presents our estimates of the benefit payments for defined benefit pension and other post-employment plans. Benefits payment projection 2007 2008 2009 2010 2011 2012–2016 Other post-employment plans Pension plans $ $ 327 324 351 363 369 2,017 63 66 74 79 83 475 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 1.9 million (2005 – 1.7 million, adjusted for stock dividend) of our com- mon shares having a fair value of $94 million (2005 – $70 million). Dividends amounting to $2.5 million (2005 – $1.6 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 Equity securities Debt securities Total Actual 2006 60% 40% 100% 2005 60% 40% 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 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 Service cost Interest cost Expected return on plan assets Amortization of transitional asset Amortization of prior service cost Amortization of actuarial loss Other Defined benefit pension expense Defined contribution pension expense Pension benefit expense Weighted average assumptions to calculate pension benefit expense Discount rate Assumed long-term rate of return on plan assets Rate of increase in future compensation Other post-employment benefit expense Service cost Interest cost Expected return on plan assets Amortization of transitional obligation Amortization of actuarial loss Amortization of prior service cost Curtailment gain Other post-employment benefit expense Weighted average assumptions to calculate other post-employment benefit expense Discount rate Rate of increase in future compensation $ $ $ 2006 2005 2004 173 345 (364) (2) 32 138 3 325 65 390 $ $ 138 344 (328) (2) 32 90 3 277 63 340 $ $ 136 330 (315) (2) 32 84 – 265 64 329 5.25% 7.00% 4.40% 6.25% 7.00% 4.40% 6.25% 7.00% 4.40% 2006 2005 2004 $ 26 77 (2) 3 31 (20) (8) $ 49 101 (2) 17 30 1 (1) 72 99 (1) 17 26 1 – $ 107 $ 195 $ 214 5.41% 4.40% 6.35% 4.40% 6.34% 4.40% Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 133 Note 20 Pensions and other post-employment benefits (continued) Significant assumptions Our methodologies to determine significant assumptions used in calcu- lating 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 2007 (7% for 2003 to 2006). 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. Sensitivity analysis The following table presents the sensitivity analysis of certain key assumptions on defined benefit pension and post-employment obligation and expense: 2006 Sensitivity of key assumptions Pension Impact of .25% change in discount rate assumption Impact of .25% change in rate of increase in future compensation assumption Impact of .25% change in the long-term rate of return on plan assets assumption Other post-employment Impact of .25% change in discount rate assumption Impact of .25% change in rate of increase in future compensation assumption Impact of 1.00% increase in health care cost trend rates Impact of 1.00% decrease in health care cost trend rates Change in obligation Change in expense $ 233 26 – $ 29 6 13 Change in obligation Change in expense $ 52 – 143 (119) $ 8 – 19 (15) 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 the 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 Defined benefit pension expense recognized Difference between expected and actual return on plan assets Difference between actuarial losses (gains) amortized and actuarial losses (gains) arising Difference between prior service costs amortized and prior service costs arising Amortization of transitional asset Defined benefit pension expense incurred Other post-employment benefit expense incurred Other post-employment benefit expense recognized Difference between expected and actual return on plan assets Difference between actuarial losses (gains) amortized and actuarial losses (gains) arising Difference between prior service costs amortized and prior service costs arising Amortization of transitional obligation Other post-employment benefit expense incurred Note 21 Stock-based compensation 2006 2005 2004 $ $ 325 (81) (100) (2) 2 $ 277 (423) 708 (31) 2 $ 144 $ 533 $ 265 (160) (50) (12) 2 45 2006 2005 2004 $ $ 107 (1) 7 (485) (3) $ 195 (2) 150 (1) (17) $ (375) $ 325 $ 214 (2) (91) (1) (17) 103 We offer stock-based compensation plans to certain key employees and to our non-employee directors. We use derivatives and compensa- tion trusts to manage our economic exposure to volatility in the price of our common shares under many of these plans. The expense amounts reported below for our stock-based compensation plans exclude the impact of these derivative instruments. 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 plans, options are periodically granted to purchase common shares at prices not less than the market price of such shares on the day of grant. The options vest over a 4-year period for employees and are exercisable for a period not exceeding 10 years from the grant date. Royal Bank of Canada Annual Report 2006 134 Consolidated Financial Statements For options issued prior to November 1, 2002, that were not accompanied by tandem stock appreciation rights (SARs), no compensa- tion 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 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 com- pensation 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 $27 million for the year ended October 31, 2006 (2005 – $42 million; 2004 – $3 million). A summary of our stock option activity and related information Outstanding at beginning of year Granted Exercised – Common shares (2), (3) – SARs Cancelled Outstanding at end of year Exercisable at end of year Available for grant 2006 2005 (1) 2004 (1) Number of options (000s) Weighted average exercise price Number of options (000s) Weighted average exercise price Number of options (000s) Weighted average exercise price 36,481 1,756 (5,617) (143) (234) 32,243 26,918 23,121 $ $ $ 23.15 44.13 20.40 21.60 24.36 24.66 22.57 44,744 2,054 (9,917) (320) (80) 36,481 28,863 24,500 $ $ $ 22.02 31.70 19.85 21.01 30.44 23.15 21.56 49,606 2,378 (6,657) (352) (231) 44,744 32,801 26,430 $ $ $ 21.03 31.32 17.97 20.68 23.93 22.02 20.21 (1) (2) (3) The number of options and weighted average exercise price for 2005 and 2004 have been adjusted for the stock dividend paid on April 6, 2006. Refer to Note 18. Cash received for options exercised during the year was $115 million (2005 – $197 million; 2004 – $119 million). New common shares were issued for all options exercised in 2006, 2005 and 2004. Refer to Note 18. Options outstanding and options exercisable as at October 31, 2006 by range of exercise price $10.00 – $15.00 (2) $15.45 – $19.82 $21.79 – $25.00 $26.09 – $29.68 $31.31 – $44.13 Total Options outstanding (1) Options exercisable (1) Number outstanding (000s) Weighted average exercise price $ 1,055 9,724 12,176 3,365 5,923 11.60 18.27 24.56 29.01 35.24 32,243 $ 24.66 Weighted average remaining contractual life 2.3 2.2 4.3 5.6 7.9 4.4 Number exercisable (000s) Weighted average exercise price $ 1,055 9,724 12,176 2,451 1,512 11.60 18.27 24.56 29.00 31.44 26,918 $ 22.57 (1) (2) The number of options outstanding and options exercisable have been adjusted for the stock dividend paid on April 6, 2006. Refer to Note 18. The weighted average exercise prices have been revised to reflect the conversion of non-Canadian dollar-denominated options at the exchange rate as at the balance sheet date. Fair value method CICA 3870 recommends 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, 2006, in respect of these plans was $13 million (2005 – $14 million; 2004 – $9 million). The compensa- tion expenses related to non-vested awards were $13 million at October 31, 2006 (2005 – $16 million; 2004 – $18 million), to be recog- nized over the weighted average period of 2.0 years (2005 – 1.7 years; 2004 – 2.4 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: Net income from continuing operations Net income (loss) from discontinued operations (3) Net income Basic earnings (loss) per share (4) From continuing operations From discontinued operations Total Diluted earnings (loss) per share (4) From continuing operations From discontinued operations Total 2006 4,757 (29) As reported 2005 $ 3,437 (50) $ 2004 3,023 (220) Pro forma (1), (2) 2005 $ 3,424 (50) $ 2004 2,991 (220) 4,728 $ 3,387 $ 2,803 $ 3,374 $ 2,771 3.67 (.02) $ 2.65 (.04) $ 2.31 (.17) $ 2.64 (.04) $ 3.65 $ 2.61 $ 2.14 $ 2.60 $ 3.61 (.02) $ 2.61 (.04) $ 2.28 (.17) $ 2.60 (.04) $ 3.59 $ 2.57 $ 2.11 $ 2.56 $ 2.29 (.17) 2.12 2.26 (.17) 2.09 $ $ $ $ $ $ (1) (2) (3) (4) 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. 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, 2006. Refer to Note 11. The basic and diluted earnings per share have been adjusted retroactively for the stock dividend paid on April 6, 2006. Refer to Note 18. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 135 We offer performance deferred 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 common shares held in trust as at October 31, 2006, was 5.3 million (2005 – 7.3 million; 2004 – 8.1 million). The value of the DSUs liability as at October 31, 2006, was $153 million (2005 – $38 million; 2004 – $1 million). The compensation expense recorded for the year ended October 31, 2006, in respect of these plans was $148 million (2005 – $109 million; 2004 – $80 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, 2006, was $289 million (2005 – $236 million; 2004 – $155 million). The compensation expense recorded for the year ended October 31, 2006, was $110 million (2005 – $90 million; 2004 – $56 million). On the acquisition of Dain Rauscher, certain key employees of Dain Rauscher were offered retention unit awards totalling $318 million to be paid out evenly over expected service periods of between three and four years. During fiscal 2005, these retention unit awards were fully paid out to participants based on the market value of common shares on the vesting date. The liability under this plan as at October 31, 2006, was nil (2005 – nil; 2004 – $36 million). The compen- sation expense recorded for the year ended October 31, 2006, in respect of this plan was nil (2005 – $1 million; 2004 – $16 million). Our stock-based compensation plan included a mid-term compen- sation plan for certain senior executive officers. The last award under this plan was granted in 2001, which was paid out in 2004. For other stock-based plans, compensation expense of $10 million was recognized for the year ended October 31, 2006 (2005 – $8 million; 2004 – $5 million). The liability for the share units held under these plans as at October 31, 2006, was $4 million (2005 – $19 million; 2004 – $16 million). The number of common shares held under these plans was .3 million (2005 – .3 million; 2004 – .4 million). Note 21 Stock-based compensation (continued) The fair value of options granted during 2006 was estimated at $6.80 (2005 – $4.66; 2004 – $5.47) using an option pricing model on the date of grant. The following assumptions were used: For the year ended October 31 2006 2005 2004 Weighted average assumptions Risk-free interest rate Expected dividend yield Expected share price volatility Expected life of option 3.98% 3.16% 17% 6 years 3.75% 3.25% 17% 6 years 4.22% 2.90% 18% 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 common shares. For the RBC Dominion Securities Savings Plan, our maximum annual contribution is $4,500 per employee. For the RBC UK Share Incentive Plan, our maximum annual contribution is £1,500 per employee. In 2006, we contributed $60 million (2005 – $56 million; 2004 – $54 million), under the terms of these plans, towards the purchase of common shares. As at October 31, 2006, an aggregate of 34.7 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 previously to certain key employees. Under these plans, the executives or directors may choose to receive all or a percentage of their annual 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 fiscal 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, 2006, was $221 million (2005 – $172 million; 2004 – $120 million). The share price fluctuations and dividend equivalents compensation expense recorded for the year ended October 31, 2006, in respect of these plans was $44 million (2005 – $42 million; 2004 – $3 million). We have a deferred bonus plan for certain key employees within RBC Capital Markets. Under this plan, a percentage of each employee’s annual incentive bonus is deferred and accumulates dividend equiva- lents 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, 2006, was $401 million (2005 – $320 million; 2004 – $241 million). The share price fluctuations and dividend equivalents compensation expense for the year ended October 31, 2006, in respect of this plan was $51 million (2005 – $57 million; 2004 – $4 million). Royal Bank of Canada Annual Report 2006 136 Consolidated Financial Statements Note 22 Trading revenue 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 on its acquisition or its issuance. Non-interest income includes realized and unrealized gains and losses from the purchase and sale of securities, and realized and unrealized gains and losses on trading derivative financial instruments. Trading revenue Net interest income Non-interest income Total Note 23 Business realignment charges 2006 (539) $ 2,574 2005 21 1,594 2,035 $ 1,615 $ $ 2004 286 1,563 1,849 $ $ During the year, we continued to implement the additional cost-reduction activities identified during 2005 (the additional initiatives). The objec- tives of these additional initiatives are consistent with those approved by the Board of Directors on September 9, 2004, in connection with our business realignment. The objectives of the business realignment were to reduce costs, accelerate revenue growth, and improve the efficiency of our operations in order to better serve our clients. The following table sets out the changes in our business realignment charges since November 1, 2004. Although the majority of the initiatives were substantially completed during fiscal 2006, the associated income-protection payments to severed employees and certain lease obligations will extend beyond that time. The $43 million business realignment charges pertaining to continuing operations to be paid in future periods are recorded in Other liabilities on the Consolidated Balance Sheets while the $14 million pertaining to RBC Mortgage, which is accounted for as discontinued operations (refer to Note 11), is recorded in Liabilities of operations held for sale. The charges recorded by each segment during the year are disclosed in Note 30. Business realignment charges Balance as at October 31, 2004 for continuing operations Initial initiatives Reversal for positions not eliminated Accrual for new positions identified Additional initiatives Other adjustments including foreign exchange Cash payments Balance as at October 31, 2005 for continuing operations Initial initiatives Reversal for positions not eliminated Accrual for new positions identified Adjustments for positions eliminated Additional initiatives Reversal for positions not eliminated Adjustments for closure of operations centres Other adjustments including foreign exchange Cash payments Balance as at October 31, 2006 for continuing operations Balance as at October 31, 2004 for discontinued operations Adjustments for closure of branches and headquarters Cash payments Balance as at October 31, 2005 for discontinued operations Adjustments for closure of branches and headquarters Cash payments Balance as at October 31, 2006 for discontinued operations Total balance as at October 31, 2006 Employee-related Premises-related charges charges Other $ 13 $ $ 164 $ (55) 52 43 (4) (82) $ 118 $ (1) 3 6 (11) – (1) (73) 41 2 1 (2) 1 – (1) – 41 $ $ $ $ $ $ $ $ $ $ – – – – – – – – – – – 3 – (1) 2 13 12 (13) 12 6 (4) 14 16 – – – (1) (12) – – – – – – – – – – – – – – – – – $ $ $ $ $ $ Total 177 (55) 52 43 (5) (94) $ 118 (1) 3 6 (11) 3 (1) (74) 43 15 13 (15) 13 6 (5) 14 57 $ $ $ $ $ Our business realignment charges include the income-protection pay- ments for severed employees. For continuing operations, the number of employee positions identified for termination decreased to 1,866 from 2,063 at October 31, 2005. The decrease in the accrual corresponds to the net decrease of 197 positions which is comprised of the following: for the original and additional initiatives, 19 and 215 positions were reinstated, respectively, and 37 new positions were identified for elimi- nation. As at October 31, 2006, 1,980 employees had been terminated, 164 of whom related to RBC Mortgage. In 2006, we closed 3 operation centres related to the additional initiatives. In 2005, we closed the Chicago headquarters of RBC Mortgage and 40 of its branches. Although we have vacated these prem- ises, we remain the lessee; accordingly, we have accrued the fair value of the remaining future lease obligations. We expensed the lease cancella- tion payments for those locations for which we have legally extinguished our lease obligation. The carrying value of redundant assets in the closed premises has been included in premises-related costs. We also incurred approximately $4 million in 2005 in connection with employee outplacement services. The other charges represent fees charged by a professional services firm for strategic and organizational advice provided to us with respect to the business realignment initiatives. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 137 Note 24 Income taxes Income taxes in Consolidated Statements of Income Continuing operations Current Canada – Federal – Provincial International Future Canada – Federal – Provincial International Subtotal Discontinued operations Current International Future International Subtotal Income taxes (recoveries) in Consolidated Statements of Changes in Shareholders’ Equity Continuing operations Unrealized foreign currency translation gain, net of hedging activities Issuance costs Stock appreciation rights Wealth accumulation plan gains Other Subtotal Total income taxes Sources of future income taxes Future income tax asset Allowance for credit losses Deferred compensation Pension related Business realignment charges Tax loss carryforwards Deferred income Enron litigation provision Other Valuation allowance Future income tax liability Premises and equipment Deferred expense Other Net future income tax asset 2006 2005 2004 $ $ 506 331 435 $ 739 431 478 659 338 217 1,272 1,648 1,214 104 31 (4) 131 (206) (96) (68) (370) 12 12 49 73 1,403 1,278 1,287 (20) 2 (35) 3 (59) 4 1,385 1,246 1,232 130 (4) 4 – 6 136 204 2 5 7 2 220 328 – 3 – (1) 330 $ 1,521 $ 1,466 $ 1,562 $ 2006 2005 $ 439 616 101 27 68 151 253 335 1,990 (10) 1,980 (214) (225) (437) (876) 464 545 168 38 25 160 265 331 1,996 (11) 1,985 (183) (245) (309) (737) $ 1,104 $ 1,248 Included in the tax loss carryforwards amount is $31 million of future income tax assets related to losses in our Canadian and U.S. operations (2005 – $3 million) which expire in 10 to 20 years from origination. Also included in the tax loss carryforwards amount is a $27 million tax asset related to capital losses (2005 – $11 million), which has no expiry date. 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. Royal Bank of Canada Annual Report 2006 138 Consolidated Financial Statements Reconciliation to statutory tax rate Income taxes at Canadian statutory tax rate Increase (decrease) in income taxes resulting from Lower average tax rate applicable to subsidiaries Tax-exempt income from securities Tax rate change Other Income taxes reported in Consolidated Statements of Income before discontinued operations and effective tax rate 2006 2005 2004 $ 2,152 34.7% $ 1,632 34.7% $ 1,513 35.0% (599) (184) 13 21 (9.6) (3.0) .2 .3 (251) (85) – (18) (5.3) (1.8) – (.4) (164) (54) (10) 2 (3.8) (1.3) (.2) .1 $ 1,403 22.6% $ 1,278 27.2% $ 1,287 29.8% 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 $822 million as at October 31, 2006 (2005 – $745 million; 2004 – $714 million). Note 25 Earnings per share (1) Basic earnings per share Net income from continuing operations Net income (loss) from discontinued operations (2) Net income Preferred share dividends Net gain on redemption of preferred shares Net income available to common shareholders Average number of common shares (in thousands) Basic earnings (loss) per share Continuing operations Discontinued operations Total Diluted earnings per share Net income available to common shareholders Average number of common shares (in thousands) Stock options (3) Issuable under other stock-based compensation plans Average number of diluted common shares (in thousands) Diluted earnings (loss) per share Continuing operations Discontinued operations Total 2006 2005 2004 $ $ $ 4,757 (29) 4,728 (60) – 3,437 (50) 3,387 (42) 4 3,023 (220) 2,803 (31) – $ 4,668 $ 3,349 $ 2,772 1,279,956 1,283,433 1,293,465 $ $ $ 3.67 (.02) $ 2.65 (.04) $ 3.65 $ 2.61 $ 2.31 (.17) 2.14 4,668 $ 3,349 $ 2,772 1,279,956 14,573 5,256 1,283,433 13,686 7,561 1,293,465 12,151 5,400 1,299,785 1,304,680 1,311,016 $ $ 3.61 (.02) $ 2.61 (.04) $ 3.59 $ 2.57 $ 2.28 (.17) 2.11 (1) (2) (3) The average number of common shares, average number of diluted common shares, and basic and diluted earnings per share have been adjusted retroactively for the stock dividend paid on April 6, 2006. Refer to Note 18. Refer to Note 11. The dilutive effect of stock options was calculated using the treasury stock method. During 2006 and 2005, no option was outstanding with an exercise price exceeding the average market price of our common shares. For 2004, we excluded from the calculation of diluted earnings per share 2,174,376 average options outstanding with an exercise price of $31.32 as the exercise price of these options was greater than the average market price of our common shares. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 139 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 con- tractual 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 par- ticular 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: 2006 2005 Canada % United States % Europe Other Inter- % national % Total Canada % United States % Europe Other Inter- % national % Total $ 204,488 73% $ 41,467 15% $ 27,358 10% $ 5,112 2% $ 278,425 $ 186,663 77% $ 32,366 13% $ 18,813 8% $ 4,119 2% $ 241,961 $ 78,851 55% $ 51,224 35% $ 12,997 9% $ 1,802 1% $ 144,874 $ 68,391 53% $ 46,221 35% $ 13,014 10% $ 2,542 2% $ 130,168 68,228 33,608 49 22,609 33 11,835 18 19,776 33 28,563 47 11,563 19 60,640 738 176 1 – 9,855 27 9,171 25 15,891 42 2,148 6 37,065 10,276 27 9,682 25 16,638 42 2,146 6 38,742 $ 117,269 48% $ 71,958 30% $ 48,664 20% $ 4,688 2% $ 242,579 $ 112,275 47% $ 67,738 29% $ 52,261 22% $ 4,864 2% $ 237,138 On-balance sheet assets (1) Off-balance sheet credit instruments (2) Committed and uncommitted (3) Other Derivatives before master netting agreement (4), (5) (1) (2) (3) (4) (5) Includes assets purchased under reverse repurchase agreements and securities borrowed, loans and customers’ liability under acceptances. The largest concentrations in Canada are Ontario at 52% (2005 – 41%), Quebec at 15% (2005 – 10%), the Prairies at 14% (2005 – 12%), and British Columbia at 14% (2005 – 11%). No industry accounts for more than 10% of total on-balance sheet credit instruments. Represents financial instruments with contractual amounts representing credit risk. Of the commitments to extend credit, the largest industry concentrations relate to financial services of 38% (2005 – 37%), government of 5% (2005 – 6%), commercial real estate of 6% (2005 – 5%), transportation of 3% (2005 – 5%), wholesale of 5% (2005 – 5%), manufacturing of 4% (2005 – 4%), and mining and energy of 13% (2005 – 13%). The largest concentration by counterparty type of this credit exposure is with banks at 59% (2005 – 60%). Excludes credit derivatives classified as “other than trading” with a replacement cost of $20 million (2005 – $20 million) which are given guarantee treatment. Note 27 Guarantees, commitments and contingencies Guarantees In the normal course of our business, we enter into numerous agree- ments that may contain features that meet the definition of a guarantee pursuant to CICA Accounting Guideline 14, Disclosure of Guarantees (AcG-14). AcG-14 defines a guarantee to be a contract (including an indemnity) that contingently requires us to make payments (either in cash, financial instruments, 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. The maximum potential amount of future payments represents the maximum risk of loss if there were 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: Credit derivatives and written put options (1), (2) Backstop liquidity facilities Stable value products (2) Financial standby letters of credit and performance guarantees (3) Credit enhancements Mortgage loans sold with recourse (4) Securities lending indemnifications (5) 2006 2005 $ Maximum potential amount of future payments $ 54,723 34,342 16,098 15,902 4,155 204 – Maximum potential amount of future payments Carrying amount 352 – – 17 – – – $ 28,662 29,611 12,567 14,417 3,179 388 32,550 $ Carrying amount 465 – – 16 – – – (1) (2) (3) (4) (5) The carrying amount is included in Other – Derivative-related amounts on our Consolidated Balance Sheets. The notional amount of these contracts appropriates the maximum potential amount of future payments. The carrying amount is included in Other – Other liabilities on our Consolidated Balance Sheets. As at October 31, 2006, the amount related to discontinued operations was nil (October 31, 2005 – $174 million). Refer to Note 11. The October 31, 2005 amount was revised to include the $174 million. Substantially all of our securities lending activities are now transacted through our new joint venture, RBC Dexia IS. As at October 31, 2006, RBC Dexia IS securities lending indemnifications totalled $45,614 million (2005 – nil); 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 Royal Bank of Canada Annual Report 2006 140 Consolidated Financial Statements 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 guar- antees include foreign exchange contracts, equity-based contracts and certain commodity-based contracts. The terms of these options vary 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. Securities lending indemnifications In securities lending transactions, we act 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 collateral- ize the security loaned at all times. As part of this custodial business, an indemnification may be provided to security 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. The majority of the collateral held for our securi- ties lending transactions includes cash, equities, convertible bonds, and securities that are issued or guaranteed by the Canadian govern- ment, U.S. government or other OECD countries. 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. The liquidity facilities’ terms can range up to five years. 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, 457 plans, etc. 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 repre- sent 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 admin- istered by us to protect commercial paper investors in the event that the collection of the underlying assets, the transaction-specific credit enhancement or the liquidity proves to be insufficient to pay for matur- ing 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. Indemnifications In the normal course of our operations, we provide indemnifications which are often standard contractual terms to counterparties in trans- actions such as purchase and sale contracts, service agreements, director/officer contracts and leasing transactions. These indemnifica- tion 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 poten- tial amount we could be required to pay to counterparties. Historically, we have not made any significant payments under such indemnifications. Off-balance sheet credit instruments We utilize 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 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 con- tract. 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. Guarantees and standby letters of credit include credit enhance- ment facilities, written put options, other-than-trading credit derivatives, and standby and performance guarantees. These instru- ments represent irrevocable assurances that we will make payments in the event that a client cannot meet its obligations to third parties. 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. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 141 Note 27 Guarantees, commitments and contingencies (continued) The following table summarizes the contractual amounts of our off-balance sheet credit instruments: 2006 2005 $ 57,154 42,222 38,185 45,498 21,734 713 8 $ 50,843 34,410 48,750 44,915 18,786 685 7 $ 205,514 $ 198,396 2006 2005 $ 100 1,936 187 56,580 36,788 941 $ 64 1,488 624 31,915 36,878 626 $ 96,532 $ 71,595 2006 2005 $ 1,794 2,309 $ 1,370 1,510 38,118 44,651 6,547 3,113 27,532 32,266 5,506 3,411 $ 96,532 $ 71,595 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) 2007 2008 2009 2010 2011 Thereafter $ 419 378 326 268 227 868 $ 2,486 (1) Substantially all of our lease commitments are related to operating leases. Off-balance sheet credit instruments Commitments to extend credit (1) Original term to maturity of 1 year or less Original term to maturity of more than 1 year Securities lending Uncommitted amounts Guarantees and standby letters of credit Documentary and commercial letters of credit Note issuance and revolving underwriting facilities (1) Includes liquidity facilities. 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 Cash and due from banks Interest-bearing deposits with banks Loans Securities Assets purchased under reverse repurchase agreements Other assets Assets pledged to: Foreign governments and central banks Clearing systems, payment systems and depositories Assets pledged in relation to: Securities borrowing and lending Obligations related to securities sold under repurchase agreements Derivative transactions Other Collateral As at October 31, 2006, the approximate market value of collateral accepted that may be sold or repledged by us was $109.1 billion (2005 – $82.2 billion). This collateral was received in connection with reverse repurchase agreements, securities borrowings and loans, and derivative transactions. Of this amount, $48.0 billion (2005 – $47.8 billion) has been sold or repledged, generally as collateral under repurchase agreements or to cover short sales. Royal Bank of Canada Annual Report 2006 142 Consolidated Financial Statements 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). This case has been consolidated with the lead action entitled Newby v. Enron Corp., which is the main consolidated purported Enron shareholder class action wherein similar claims have been made against numerous other financial institutions, law firms, accountants, and certain current and former officers and directors of Enron. 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 pur- chasers 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 manner as we believe to be in our best interests. As with any litigation, there are sig- nificant 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 cur- rent 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 litiga- tion 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 operat- ing results for the particular period in which the resolution occurs, notwithstanding the provision established in 2005. We will continue to vigorously defend ourselves in these cases. On July 27, 2005, Royal Bank of Canada reached an agreement to settle its part of the MegaClaims lawsuit brought by Enron in the United States Bankruptcy Court for the Southern District of New York against Royal Bank of Canada and a number of other financial institu- tions. Under the agreement, Royal Bank of Canada agreed to pay Enron, and expensed in the third quarter of 2005, $31 million (US$25 million) in cash to settle the claims that have been asserted by Enron against the bank and certain related entities. Enron allowed $140 million (US$114 million) in claims filed against the Enron bankruptcy estate by the bank, including a $61 million (US$50 million) claim previously transferred by the bank, that were the subject of a separate proceed- ing in the bankruptcy court, in exchange for a cash payment to Enron of $29 million (US$24 million) which was expensed in the fourth quarter of 2005. The agreement was approved by U.S. federal bankruptcy court on November 29, 2005, and resolved all claims between the bank and Enron related to Enron’s bankruptcy case. Payment was made by us in fiscal 2006 in accordance with the agreement and all actions by the Enron estate against Royal Bank of Canada were dismissed. Other Various other legal proceedings are pending that challenge certain of our practices or actions. We consider that the aggregate liability result- ing from these other proceedings will not be material to our financial position or results of operations. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 143 Note 28 Contractual repricing and maturity schedule The table below details our exposure to interest rate risk as defined and prescribed by the CICA Handbook Section 3860, Financial Instruments – Disclosure and Presentation. On- and off-balance sheet financial instruments are reported based on the earlier of their contractual repric- ing 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 table below does not incorporate management’s expectation of Carrying amount by earlier of contractual repricing or maturity date future events where expected repricing or maturity dates differ signifi- cantly 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, 2006, would result in a change in the under one-year gap from $(79.8) billion to $(40.2) billion (2005 – $(79.5) billion to $(39.7) billion). Immediately rate-sensitive Under 3 months 3 to 6 months Over 6 to 12 months Over 1 to 5 years Over 5 years Non-rate- sensitive Total Assets Cash and deposits with banks Effective interest rate Securities Trading account Effective interest rate Investment account and loan substitute Effective interest rate Assets purchased under reverse repurchase agreements Effective interest rate Loans (net of allowance for loan losses) Effective interest rate Other assets $ – $ 11,104 4.33% – $ $ – – – $ 2,036 4.22% – $ – $ 1,763 $ 14,903 – – – – – – 30,399 4.69% 10,163 4.90% – – 92,469 – – 58,454 5.14% 21,230 5.93% – $$ 92,469 $ 131,350 5,706 4.69% 1,346 4.93% 924 4.33% 8,288 5.56% – $ 16,264 5,238 4.62% 1,781 4.94% 24,093 4.62% 14,378 4.58% 23,436 4.85% 6,809 4.80% 58,365 – 3,155 – 147,237 37,632 – – 11,953 5.49% – – – 68,574 5.28% – $ 18,972 $ 109,081 59,378 – – 5,873 5.96% – – – 143 – 69,100 69,100 $ 36,118 $ 132,526 $ 536,780 208,530 Liabilities Deposits Effective interest rate Obligations related to assets sold under repurchase agreements Effective interest rate Obligations related to securities sold short Effective interest rate Other liabilities Effective interest rate Subordinated debentures Effective interest rate Non-controlling interest in subsidiaries Effective interest rate Shareholders’ equity Effective interest rate On-balance sheet gap Off-balance sheet financial instruments (1) Derivatives used for asset/liability management purposes Pay side instruments Effective interest rate Receive side instruments Effective interest rate Derivatives used for trading purposes Effective interest rate Total off-balance sheet financial instruments $ Total gap Canadian dollar Foreign currency Total gap Canadian dollar – 2005 Foreign currency – 2005 Total gap – 2005 $$ 137,738 $ 103,805 4.44% – $ 18,085 4.31% $ 31,312 $ 43,391 3.79% 3.92% – – – – – – – – – – – – – 886 39,191 – 4.33% 4.74% 10,769 195 757 4.53% 4.49% 4.44% 650 – – 7.29% – – 4,413 – 912 5.12% – 5.51% 1,200 – – 4.87% – – – – 150 – – 5.50% $$ 137,738 $ 144,815 $ 32,596 $ 60,423 $ 19,166 $$ (45,269) $ (13,465) $ (2,902) $ (13,624) $ 48,658 491 4.28% 310 4.54% – – 483 6.75% – – – – $ 5,454 $ 3,738 $ 343,523 4.86% – – 10,442 4.59% 750 7.18% 1,295 6.48% – – 900 4.68% – 535 – 15,779 – 81,501 – – – 575 – 21,073 – 41,103 38,252 82,901 7,103 1,775 22,123 $ 18,841 $ 123,201 $ 536,780 – $ 17,277 $ 9,325 $ (961) $ (2,328) $ (27,368) $ (7,204) $ $ 4.22% 4,932 4.68% 6,884 4.31% 4.35% 4,980 4.32% (15,811) 4.33% – $ (42,054) $ 4.41% 4.34% – 19,145 40,333 – 4.61% 4.34% – 26,784 – (517) 4.22% 4.33% – – $ (2,238) $ (11,792) $ 9,488 $ 18,561 $$ (45,269) $ (15,703) $ (14,694) $ (4,136) $ 67,219 52,937 14,282 $$ (45,269) $ (15,703) $ (14,694) $ (4,136) $ 67,219 $ (6,791) $ 48,941 18,045 $$ (29,385) $ (32,154) $ (16,773) $ (1,191) $ 66,986 $ (14,858) $ (34,024) $ 2,619 (19,392) 1,870 (24,559) 8,856 (26,367) (18,902) 5,204 (19,898) (1,764) (2,372) (14,527) 5,600 4.77% 10,525 4.99% 12,947 4.41% – $ (79,915) – – – (30,287) – 79,915 – $ 16,268 $ (30,287) $ $ 33,545 $ (20,962) $ 11,628 21,917 (17,083) (3,879) $ 33,545 $ (20,962) $ $ 11,125 $ (7,010) $ 13,771 (5,369) $ 24,896 $ (12,379) $ – – (4) 4 – 2 (2) – (1) Represents net notional amounts. Note 29 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. Refer to Note 9. 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. Refer to Note 21. Royal Bank of Canada Annual Report 2006 144 Consolidated Financial Statements RBC Canadian Personal and Business RBC U.S. and International Personal and Business RBC Capital Markets Corporate Support Total Canada United States Other International $ 1,109 $ 201 4,492 $ (489) $ 6,762 $ 6,011 $ 180 13,875 7,552 4,397 108 $ 643 1,926 Note 30 Results by business and geographic segment 2006 Net interest income Non-interest income Total revenue Provision for (recovery of) credit losses Insurance policyholder benefits, claims and acquisition expense Non-interest expense Business realignment charges Net income (loss) before income taxes Income taxes Non-controlling interest $ 5,941 7,440 13,381 604 2,509 6,140 – 4,128 1,334 – 1,763 2,872 26 – 2,260 1 585 135 6 4,693 (115) – 3,058 (1) 1,751 364 (20) (309) (86) 20,637 429 13,563 456 4,505 (28) 2,569 1 – 37 – (260) (430) 58 2,509 11,495 – 6,204 1,403 44 1,379 7,056 – 4,672 1,458 37 683 3,038 – 447 1,401 – 812 14 (1) 720 (69) 8 781 – 781 Net income (loss) from continuing operations $ 2,794 Net loss from discontinued operations – $ 444 $ 1,407 – (29) $ 112 $ 4,757 $ 3,177 $ – (29) – 799 $ (29) Net income (loss) $ 2,794 $ 415 $ 1,407 $ 112 $ 4,728 $ 3,177 $ 770 $ Average assets from continuing operations (1) $ 200,700 Average assets from discontinued operations (1) – $ 39,000 $ 267,800 – 200 $ (5,400) $ 502,100 $ 287,200 $ 113,300 $ 101,600 – 200 200 – – Total average assets (1) $ 200,700 $ 39,200 $ 267,800 $ (5,400) $ 502,300 $ 287,200 $ 113,500 $ 101,600 2005 Net interest income Non-interest income RBC Canadian Personal and Business RBC U.S. and International Personal and Business RBC Capital Markets Corporate Support Total Canada United States Other International $ 5,348 7,151 $ 1,108 $ 607 $ 1,620 3,455 (293) $ 6,770 $ 5,605 $ 188 12,414 6,901 Total revenue Provision for (recovery of) credit losses Insurance policyholder benefits, claims and acquisition expense Non-interest expense Business realignment charges Net income (loss) before income taxes Income taxes Non-controlling interest 12,499 542 2,728 51 2,625 5,872 7 – 2,150 (2) 3,453 1,149 – 529 135 7 Net income (loss) from continuing operations $ 2,304 – Net loss from discontinued operations $ 387 $ (50) 4,062 (91) – 3,274 1 878 137 (19) 760 – (105) (47) 19,184 455 12,506 433 – 61 39 2,625 11,357 45 (158) (143) (1) 4,702 1,278 (13) 1,270 6,685 45 4,073 1,329 (30) $ (14) $ – 3,437 $ (50) 2,774 $ – 200 $ (50) 608 $ 3,955 4,563 23 809 3,595 – 136 (76) 12 557 1,558 2,115 (1) 546 1,077 – 493 25 5 463 – Net income (loss) $ 2,304 $ 337 $ 760 $ (14) $ 3,387 $ 2,774 $ 150 $ 463 Average assets from continuing operations (1) $ 182,400 – Average assets from discontinued operations (1) $ 37,700 $ 229,300 $ (4,100) $ 445,300 $ 263,200 $ 92,400 1,800 1,800 1,800 – – – $ 89,700 – Total average assets (1) $ 182,400 $ 39,500 $ 229,300 $ (4,100) $ 447,100 $ 263,200 $ 94,200 $ 89,700 2004 Net interest income Non-interest income Total revenue Provision for (recovery of) credit losses Insurance policyholder benefits, claims and acquisition expense Non-interest expense Business realignment charges Net income (loss) before income taxes Income taxes Non-controlling interest RBC Canadian Personal and Business RBC U.S. and International Personal and Business $ 4,876 6,337 11,213 410 2,124 5,630 63 2,986 943 – $ 989 $ 1,713 2,702 80 – 2,330 23 269 52 3 RBC Capital Markets 847 3,086 3,933 (108) – 2,845 27 1,169 334 8 Corporate Support Total Canada United States $ (314) $ 6,398 $ 5,011 $ 268 11,404 6,121 934 3,743 Other International $ 453 1,540 (46) (36) 17,802 346 11,132 343 4,677 61 1,993 (58) – 28 64 (102) (42) 1 2,124 10,833 177 4,322 1,287 12 909 6,395 142 3,343 1,166 6 872 3,457 29 258 45 1 343 981 6 721 76 5 640 – Net income (loss) from continuing operations $ Net loss from discontinued operations 2,043 – $ 214 $ (220) 827 $ – (61) $ – 3,023 $ (220) 2,171 – $ 212 (220) $ Net income (loss) $ 2,043 $ (6) $ 827 $ (61) $ 2,803 $ 2,171 $ (8) $ 640 Average assets from continuing operations (1) $ 164,100 – Average assets from discontinued operations (1) $ 37,100 $ 219,300 $ (2,300) $ 418,200 $ 238,000 $ 89,500 3,200 3,200 3,200 – – – $ 90,700 – Total average assets (1) $ 164,100 $ 40,300 $ 219,300 $ (2,300) $ 421,400 $ 238,000 $ 92,700 $ 90,700 (1) Calculated using methods intended to approximate the average of the daily balances for the period. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 145 Note 30 Results by business and geographic segment (continued) Revenue by business lines Banking (1) Wealth management Global insurance Global markets Global investment banking and equity markets RBC Dexia IS (2) Other (3) Total $ $ $ 2006 8,411 4,494 3,348 2,579 1,250 558 (3) 2005 7,971 3,945 3,311 2,256 979 500 222 2004 7,367 3,673 2,875 2,268 941 455 223 $ 20,637 $ 19,184 $ 17,802 (1) (2) (3) Includes cards and payment solutions. The amount for 2006 includes two months of revenue from Institutional & Investor Services 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 and 2004 only represent revenue from IIS. Consists of National Clients, Research and Global Credit, and includes the teb adjustment which is discussed below. Composition of business segments For management reporting purposes, our operations and activities are organized into three business segments: RBC Canadian Personal and Business, RBC U.S. and International Personal and Business, and RBC Capital Markets. RBC Canadian Personal and Business consists of banking and wealth management businesses in Canada and our global insurance business, and its results reflect how it is managed, inclusive of securitized assets and related amounts for income and provision for credit losses. RBC U.S. and International Personal and Business consists of our banking and retail brokerage businesses in the U.S., banking in the Caribbean and international private banking. RBC Capital Markets provides a wide range of corporate and investment banking, sales and trading, research and related products and other services. All other enterprise level activities that are not allocated to these three business segments, such as securitization and other items and net charges asso- ciated with unattributed capital, are reported under Corporate Support. Consolidation adjustments, including the elimination of the taxable equivalent basis gross-up amounts reported in Net interest income and provision for income taxes, are also included in Corporate Support. 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 three 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. Changes during 2006 During 2006, we implemented the following changes in our business segments: We started to report Net interest income, Total revenue and Net income before income taxes of our RBC Capital Markets segment on a taxable equivalent basis (teb). Net interest income from tax-advantaged sources, primarily related to Canadian taxable dividends, is grossed up to its effective tax equivalent value with a corresponding offset recorded in the provision for income taxes. Management believes these adjust- ments are necessary to reflect how RBC Capital Markets is managed since it 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 of $213 million in RBC Capital Markets (2005 – $109 million; 2004 – $55 million) is eliminated in Corporate Support. We have also implemented certain revisions to our overhead and transfer pricing methodologies, and transferred our housing tax credit syndication business from RBC U.S. and International Personal and Business to RBC Capital Markets. In addition, we reclassified changes in fair value of certain derivative instruments designated as economic hedges of our stock-based compensation plans from Non-interest income to Non-interest expense (refer to Note 1). We also reclassified certain amounts out of Non-interest income into Net interest income in our RBC Canadian Personal and Business segment to correspond with our management reporting, and the reclassification is eliminated in Corporate Support. The comparative results have been updated to reflect these changes. We have included in the Total average assets of RBC Canadian Personal and Business the residential mortgages that have been securitized; the consolidation adjustment is included in Corporate Support. The comparative amounts of Total average assets have been revised to reflect this change. 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 posi- tive 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 cur- rency and are subject to foreign exchange rate fluctuations with respect to the movement in the Canadian dollar. Royal Bank of Canada Annual Report 2006 146 Consolidated Financial Statements Note 31 Reconciliation of Canadian and United States generally accepted accounting principles The 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, the 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: Condensed Consolidated Balance Sheets Assets Cash and due from banks $ 4,401 $ (101) $ 4,300 $ 5,001 $ – $ 5,001 Interest-bearing deposits with banks 10,502 (4,223) 6,279 5,237 (32) 5,205 2006 2005 Canadian GAAP Differences U.S. GAAP Canadian GAAP Differences U.S. GAAP Securities Trading account Investment account Loan substitute Available for sale Assets purchased under reverse repurchase agreements and securities borrowed Loans (net of allowance for loan losses) Other Customers’ liability under acceptances Derivative-related amounts Premises and equipment, net Goodwill Other intangibles Reinsurance recoverables Separate account assets Assets of operations held for sale Other assets 147,237 36,976 656 – 184,869 59,378 208,530 9,108 37,729 1,818 4,304 642 – – 82 15,417 (282) (36,976) (656) 37,535 146,955 – – 37,535 125,760 34,060 675 – (977) (34,060) (675) 34,729 124,783 – – 34,729 (379) 184,490 160,495 (983) 159,512 (2,148) 57,230 42,973 – 42,973 (111) 208,419 190,416 939 191,355 – 717 (86) (61) (211) 1,182 111 – 24,893 9,108 38,446 1,732 4,243 431 1,182 111 82 40,310 7,074 38,834 1,708 4,203 409 – – 263 12,908 – 1,157 (33) 45 – 1,190 105 – 26,917 7,074 39,991 1,675 4,248 409 1,190 105 263 39,825 Liabilities and shareholders’ equity Deposits Other Acceptances Obligations related to securities sold short Obligations related to assets sold under repurchase agreements and securities loaned Derivative-related amounts Insurance claims and policy benefit liabilities Separate account liabilities Liabilities of operations held for sale Other liabilities Subordinated debentures Trust capital securities Preferred share liabilities Non-controlling interest in subsidiaries Shareholders’ equity (1) 69,100 26,545 95,645 65,399 29,381 94,780 $ 536,780 $ 19,583 $ 556,363 $ 469,521 $ 29,305 $ 498,826 $ 343,523 $ (9,466) $ 334,057 $ 306,860 $ 28 $ 306,888 9,108 38,252 41,103 42,094 7,337 – 32 22,649 – (1,188) 9,108 37,064 7,074 32,391 – 1,647 7,074 34,038 (1,141) 312 2,686 111 – 27,877 39,962 42,406 10,023 111 32 50,526 23,381 42,592 7,117 – 40 18,408 – 579 2,643 105 – 23,916 23,381 43,171 9,760 105 40 42,324 160,575 28,657 189,232 131,003 28,890 159,893 7,103 1,383 298 1,775 22,123 300 (1,383) (298) 1,083 690 7,403 – – 2,858 22,813 8,167 1,400 300 1,944 19,847 407 (1,400) (300) 1,434 246 8,574 – – 3,378 20,093 $ 536,780 $ 19,583 $ 556,363 $ 469,521 $ 29,305 $ 498,826 (1) Included in our consolidated earnings as at October 31, 2006 was $293 million undistributed earnings of our joint ventures and investments accounted for using the equity method under U.S. GAAP. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 147 Note 31 Reconciliation of Canadian and United States generally accepted accounting principles (continued) Condensed Consolidated Statements of Income Net income from continuing operations, Canadian GAAP Differences: Net interest income Derivative instruments and hedging activities Variable interest entities Joint ventures Liabilities and equity Non-interest income Insurance accounting Derivative instruments and hedging activities Reclassification of securities Variable interest entities Limited partnerships Joint ventures Other Provision for (recovery of) credit losses Reclassification of securities Joint ventures Insurance policyholder benefits, claims and acquisition expense Insurance accounting Non-interest expense Stock appreciation rights Insurance accounting Joint ventures Variable interest entities Other Income taxes and net differences in income taxes due to the above items Non-controlling interest in net income of subsidiaries Variable interest entities Joint ventures Liabilities and equity Net income from continuing operations, U.S. GAAP Net loss from discontinued operations, Canadian GAAP Difference – Other Net loss from discontinued operations, U.S. GAAP Net income, U.S. GAAP Basic earnings per share (1), (2) Canadian GAAP U.S. GAAP Basic earnings per share from continuing operations Canadian GAAP U.S. GAAP Basic earnings (loss) per share from discontinued operations Canadian GAAP U.S. GAAP Diluted earnings per share (1), (2) Canadian GAAP U.S. GAAP Diluted earnings per share from continuing operations Canadian GAAP U.S. GAAP Diluted earnings (loss) per share from discontinued operations Canadian GAAP U.S. GAAP 2006 2005 2004 $ 4,757 $ 3,437 $ 3,023 (22) – (75) 115 (544) (31) 14 (10) (3) (458) (33) – 2 471 16 75 440 2 29 95 8 3 (101) 36 – – 115 (606) 11 27 – (9) (171) (4) – 18 584 25 72 118 – – (13) – – (101) 10 (19) – 166 (603) (1) 7 – (11) (146) – (1) – 582 (3) 47 114 (35) (1) 35 52 – (152) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4,750 $ 3,539 $ 3,064 (29) $ (50) $ – 5 (220) (5) (29) $ (45) $ (225) 4,721 $ 3,494 $ 2,839 3.65 3.62 3.67 3.64 $ $ $ $ 2.61 2.67 2.65 2.71 $ $ $ $ 2.14 2.16 2.31 2.33 (.02) $ (.02) $ (.04) $ (.04) $ (.17) (.17) 3.59 3.57 3.61 3.59 $ $ $ $ 2.57 2.63 2.61 2.67 $ $ $ $ 2.11 2.13 2.28 2.30 (.02) $ (.02) $ (.04) $ (.04) $ (.17) (.17) (1) (2) Two-class method of calculating earnings per share: The impact of calculating earnings per share using the two-class method reduced U.S. GAAP basic and diluted earnings per share for the years ended October 31, 2006, 2005 and 2004 by less than one cent. Please refer to material differences between Canadian and U.S. GAAP for details of this two-class method. The basic and diluted earnings per share have been adjusted retroactively for the stock dividend paid on April 6, 2006. Refer to Note 18. Royal Bank of Canada Annual Report 2006 148 Consolidated Financial Statements Condensed Consolidated Statements of Cash Flows (1) Cash flows from (used in) operating activities, Canadian GAAP U.S. GAAP adjustment for net income Adjustments to determine net cash from (used in) operating activities Provision for (recovery of) credit losses Depreciation Future income taxes Amortization of other intangibles Loss on investment in associated corporations and limited partnerships Net gain on sale of investment account securities Changes in operating assets and liabilities Insurance claims and policy benefit liabilities Net change in accrued interest receivable and payable Derivative-related assets Derivative-related liabilities Trading account securities Reinsurance recoverable Net change in brokers and dealers receivable and payable Other Net cash from (used in) operating activities, U.S. GAAP Cash flows from (used in) investing activities, Canadian GAAP Change in interest-bearing deposits with banks Change in loans, net of loan securitizations Proceeds from sale of investment account securities Proceeds from maturity of investment account securities Purchases of investment account securities Proceeds from sale of available-for-sale securities Proceeds from maturity of available-for-sale securities Purchases of available-for-sale securities Change in loan substitute securities Net acquisitions of premises and equipment Change in assets purchased under reverse repurchase agreements and securities borrowed 2006 2005 $ (14,996) $ (8) (29,527) $ 102 (2) (20) 271 (20) – – 43 (120) 440 (267) (695) (8) 3,872 2,446 (18) (4) (135) – – 3 (438) (1) 41 (90) (710) (511) (2,504) 2,099 (9,064) (31,693) (43,235) 4,191 1,050 (14,709) (28,203) 38,474 14,727 28,204 (38,383) (19) 73 2,148 (7,727) 48 28 (25,628) (18,405) 36,373 25,651 18,405 (36,130) (26) 12 – 2004 1,931 41 1 (12) 256 – 15 (59) (1,385) (83) (186) 12 314 1,620 (118) (43) 2,304 (15,765) 551 1,027 (18,427) (38,088) 50,911 18,453 38,093 (51,328) 376 22 – Net cash from (used in) investing activities, U.S. GAAP (35,682) (7,399) (14,175) Cash flows from (used in) financing activities, Canadian GAAP Change in deposits Change in deposits – Canada Change in deposits – International Issue of RBC Trust Capital Securities (RBC TruCS) Issue of preferred shares Issuance costs Issue of common shares Purchases of treasury shares Change in obligations related to assets sold under repurchase agreements and securities loaned Dividends paid Dividends/distributions paid by subsidiaries to non-controlling interests Change in obligations related to securities sold short Change in short-term borrowings of subsidiaries 57,711 (36,663) (299) 27,468 – (7) 7 1 (2) (1,141) (13) (102) (2,835) – 38,666 (35,001) 15,522 19,791 (1,200) – 3 (1) 7 – (14) (102) 2,837 (4) 14,675 (11,814) 14,927 (3,870) – – – – (12) – (14) (102) (1,078) – Net cash from (used in) financing activities, U.S. GAAP 44,125 40,504 12,712 Effect of exchange rate changes on cash and due from banks Net change in cash and due from banks Cash and due from banks at beginning of year (80) (701) 5,001 (122) 1,290 3,711 (17) 824 2,887 Cash and due from banks at end of year, U.S. GAAP $ 4,300 $ 5,001 $ 3,711 (1) Canadian and U.S. GAAP cash flow reconciling items relating to discontinued operations were not material. Accumulated other comprehensive income (loss), net of taxes (1) Unrealized gains and losses on available-for-sale securities Unrealized foreign currency translation gains and losses, net of hedging activities Gains and losses on derivatives designated as cash flow hedges Additional pension obligation Accumulated other comprehensive income (loss), net of income taxes (1) Accumulated other comprehensive income is a separate component of Shareholders’ equity under U.S. GAAP. $ $ 2006 191 (2,000) (52) (62) 2005 83 (1,768) (165) (313) $ 2004 178 (1,551) (192) (67) $ (1,923) $ (2,163) $ (1,632) Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 149 Note 31 Reconciliation of Canadian and United States generally accepted accounting principles (continued) Consolidated Statements of Comprehensive Income Net income, U.S. GAAP Other comprehensive income, net of taxes Changes in unrealized gains and losses on available-for-sale securities Changes in unrealized foreign currency translation gains and losses Impact of hedging unrealized foreign currency translation gains and losses Changes in gains and losses on derivatives designated as cash flow hedges Reclassification to earnings of gains and losses on cash flow hedges Additional pension obligation Total comprehensive income Income taxes (recovery) deducted from the above items: Changes in unrealized gains and losses on available-for-sale securities Impact of hedging unrealized foreign currency translation gains and losses Changes in gains and losses on derivatives designated as cash flow hedges Reclassification to earnings of gains and losses on cash flow hedges Additional pension obligation 2006 2005 2004 $ 4,721 $ 3,494 $ 2,839 108 (502) 270 (35) 148 251 (95) (618) 401 (97) 124 (246) 65 (1,336) 678 (147) 59 423 4,961 $ 2,963 $ 2,581 $ 57 130 (15) 75 134 (55) $ 204 (51) 66 (132) 42 328 (79) 58 245 594 Total income taxes (recovery) $ 381 $ 32 $ 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: s e i t i v i t c a g n g d e h i d n a s t n e m u r t s n i e v i t a v i r e D t s e r e t n i e l b a i r a V s e i t i t n e s e r u t n e v t n o J i As at October 31, 2006 n o i t a c fi i s s a l c e R s e i t i r u c e s f o i s p h s r e n t r a p d e t i m i L n o i t a i c e r p p a s t h g i r k c o t S s e i t i l i b a i L y t i u q e d n a l a n o i t i d d A n o i t a g i l b o n o i s n e p $ $ – – – e t a d e d a r T g n i t n u o c c a – – 60 h s a c - n o N l a r e t a l l o c – – – – – – – (25) 10,401 – – 16,558 – 37 – – – – (62) – 10,461 – – – – – – 16,558 – – – – – n a o l , s e e t n a r a u G t e s f f o f o t h g R i – – – – 852 – – 852 – – – – – d n a s t n e m t i m m o c s m e t i r o n m i r e h t o l a t o T – $ (101) – $ (4,223) (379) 1 $ – $ (2,148) (111) – $ 111 $ 26,545 – $ (9,466) 87 $ 28,657 – $ 300 – $ (1,383) – $ (298) – $ 1,083 690 25 $ – – – – – (22) – (58) – – – – 36 – – – – – – – (34) – (1,383) (298) 1,417 298 i s p h s r e n t r a p d e t i m i L n o i t a i c e r p p a s t h g i r k c o t S y t i u q e d n a s e i t i l i b a i L l a n o i t i d d A n o i s n e p n o i t a g i l b o e t a d e d a r T g n i t n u o c c a h s a c - n o N l a r e t a l l o c n a o l , s e e t n a r a u G t e s f f o f o t h g R i d n a s t n e m t i m m o c s m e t i r o n m i r e h t o l a t o T – 165 – (61) – – – – – – 104 – (140) – 127 – – – – – – (13) – – – (17) – (45) – – – – 28 – – – – – (34) – (1,400) (300) 1,434 300 – – – 167 – 480 – – – – (313) – (977) – 9,143 – – – 16,339 – 8,166 – – – – – – 16,339 – – – – – – – 897 – – 897 – – – – – – $ (31) $ – $ (32) (983) 939 125 $ 29,381 – $ 28 84 $ 28,890 407 – $ – $ (1,400) – $ (300) – $ 1,434 246 10 $ – – – 369 – (179) – – (128) – – 164 – – – – – – (15) – – – – – – 241 n o i t a c fi i s s a l c e R s e i t i r u c e s f o g n i t n u o c c a e c n a r u s n I – – – – – 2,890 – 2,777 – – – – 113 g n i t n u o c c a e c n a r u s n I – – – 2,819 – 2,661 – – – – 158 $ $ $ – – (101) (33) – – (342) (4,190) (288) Assets Cash and due from banks Interest-bearing deposits with banks Securities Assets purchased under reverse repurchase agreements and securities borrowed Loans Other assets Liabilities and shareholders’ equity Deposits Other liabilities Subordinated debentures Trust capital securities Preferred share liabilities Non-controlling interest in subsidiaries Shareholders’ equity – $ $ 41 $ 321 $ 52 (77) $ $ 300 – $ – $ – $ 54 $ – – (2) (2,148) (1,004) (3,723) – (39) – – – (305) – (9,518) (1,907) – – – (29) – As at October 31, 2005 Assets Interest-bearing deposits with banks Securities Loans Other assets Liabilities and shareholders’ equity Deposits Other liabilities Subordinated debentures Trust capital securities Preferred share liabilities Non-controlling interest in subsidiaries Shareholders’ equity s e i t i v i t c a g n g d e h i d n a s t n e m u r t s n i e v i t a v i r e D t s e r e t n i l e b a i r a V s e i t i t n e (32) $ – $ $ 42 $ 813 $ 28 $ 416 $ 407 – $ – $ – $ (28) $ – – – – – – – – – – – s e r u t n e v t n o J i – – – (74) – (74) – – – – – Royal Bank of Canada Annual Report 2006 150 Consolidated Financial Statements Material differences between Canadian and U.S. GAAP No. Item U.S. GAAP Canadian GAAP 1 Variable interest entities We began in 2004 to 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. 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 requirement. 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. 3 Derivative instruments and hedging activities All derivatives are recorded on the 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 Accumulated other comprehensive income 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. 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. Prior to 2005, we consolidated an entity when we effec- tively controlled the entity, usually through the ownership of more than 50% of the voting shares. In 2005, we adopted AcG-15, Variable Interest Entities and the treatment of VIEs is consistent in all material aspects with U.S. GAAP. The new guidance EIC-163, which is substantially the same as FSP FIN 46(R)-6, will be adopted by us in the second quarter of 2007. Refer to Note 1. 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. Derivatives embedded within hybrid instruments are generally not separately accounted for except for those related to equity-linked deposit contracts. For derivatives that do not qualify for hedge accounting, changes in their fair value are recorded in Non-interest income. Non-trading derivatives where hedge accounting has not been applied upon adoption of Accounting Guideline 13, Hedging Relationships, are recorded at fair value with transition gains or losses being recognized in income as the original hedged item affects Net interest income. Where derivatives have been designated and qualified as effective hedges, they are 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 is not required to be recognized. Upon the adoption of Section 3855 and Section 3865 on November 1, 2006, Canadian GAAP will be substan- tially harmonized with U.S. GAAP. 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 proportion- ately consolidated. 5 Insurance accounting Fixed income investments: Fixed income 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 Accumulated other comprehensive income within Shareholders’ equity. Realized gains and losses are included in Non-interest income when realized. Fixed income investments: Fixed income investments are classified as Investment account securities and carried at amortized cost. Realized gains and losses on disposal of fixed income investments that support life insurance liabili- ties are deferred and amortized to Non-interest income over the remaining term to maturity of the investments sold to a maximum period of 20 years. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 151 Note 31 Reconciliation 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 5 Insurance accounting (continued) Equity investments: Equity securities are classified as Available-for-sale securities and are carried at estimated fair value. Unrealized gains and losses, net of income taxes, are included in Accumulated other comprehensive income. Realized gains and losses are included in Non-interest income when realized. Insurance claims and policy benefit liabilities: Liabilities for 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. Insurance revenue: Amounts received for universal life and other investment-type contracts are not included as rev- enue, but are reported as deposits to policyholders’ account balances in Insurance claims and policy benefit liabilities. Revenue from these contracts is limited to amounts assessed against policyholders’ account balances for mortality, policy administration and surrender charges, and is included in Non-interest income when earned. Payments upon maturity or surrender are reflected as reductions in the Insurance claims and policy benefit liabilities. 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. 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. Reinsurance: Reinsurance recoverables are recorded as an asset on the Consolidated Balance Sheets. Equity investments: Equity securities included in the Investment account securities are initially recorded at cost. The carrying value of equity securities that support life insur- ance liabilities is adjusted quarterly by 5% of the difference between market value and the previously adjusted carrying cost. Realized gains and losses are deferred and recognized as Non-interest income at the quarterly rate of 5% of unamortized deferred gains and losses. Insurance claims and policy benefit liabilities: Liabilities for life insurance contracts are determined using the Canadian Asset Liability Method, which incorporates assumptions for mortal- ity, 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. 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: The costs of acquiring new life insur- ance and annuity business are implicitly recognized as a reduction in Insurance claims and policy benefit liabilities. Value of business acquired: The value of life insurance in-force policies acquired in a business combination is implicitly recognized as a reduction in Insurance claims and policy benefit liabilities. 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 the Consolidated Balance Sheets. Separate accounts: Assets and liabilities of separate accounts (known as segregated funds in Canada) are not recognized on the Consolidated Balance Sheets. Royal Bank of Canada Annual Report 2006 152 Consolidated Financial Statements No. Item U.S. GAAP Canadian GAAP 6 Reclassification of securities Securities are classified as Trading account or Available-for-sale, and are carried on the 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 Accumulated other comprehensive income 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 impair- ment in the value of Available-for-sale securities are included in Non-interest income. Securities are classified as Trading account (carried at estimated fair value), Investment account (carried at amortized cost) or Loan substitute. Writedowns to reflect other-than-temporary impairment in the value of Investment account securities are included in Non- interest income. Loan substitute securities are accorded the accounting treatment applicable to loans and, if required, are reduced by an allowance. Upon adoption of Section 3855 on November 1, 2006, Canadian GAAP will be substantially harmonized with U.S. GAAP. We use the equity method to account for investments in limited partnerships that are non-VIEs or unconsoli- dated VIEs, if we have the ability to exercise significant influence, which is generally indicated by an ownership interest of 20% or more. For such a plan, a liability is recorded for the poten- tial cash payments to participants and compensation expense is measured assuming that all participants will exercise SARs. 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. 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 par- ticipants would receive a cash payment equal to the difference between the closing price of our common shares on the day imme- diately 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 partici- pants exercising SARs rather than the corresponding options. 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 par- ticipants 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 Additional pension obligation For defined benefit pension plans, an unfunded accumulated benefit obligation should be recorded as an additional minimum pension liability, an intangible asset should be recorded up to the amount of unrecognized prior service cost, and the excess of unfunded accumulated benefit obligation over unrecognized prior service cost should be recorded as a reduction in Other comprehensive income. There is no requirement to recognize additional pension obligation. 10 Trade date accounting For securities transactions, trade date basis of accounting is used for both the Consolidated Balance Sheets and the Consolidated Statements of Income. For securities transactions, settlement date basis of accounting is used for the Consolidated Balance Sheets whereas trade date basis of accounting is used for the Consolidated Statements of Income. 11 Non-cash collateral Non-cash collateral received in securities lending transactions is recorded on the 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 the Consolidated Balance Sheets. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 153 Note 31 Reconciliation 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 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. Canadian GAAP only provides for disclosure requirements. Upon the adoption of Section 3855 on November 1, 2006, Canadian GAAP will be 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. 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. 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. Significant acquisitions There was no Canadian and U.S. GAAP difference resulting from our acquisitions completed in 2006, and we did not have a significant acquisition in 2005. The following table presents the differences in the allocation of pur- chase considerations due to Canadian and U.S. GAAP differences as explained in Item 5 Insurance accounting above for significant acquisi- tions that occurred in 2004: 2004 Provident William R. Hough UnumProvident (1) Canadian GAAP Difference U.S. GAAP Canadian GAAP Difference U.S. GAAP Canadian GAAP Difference U.S. GAAP VOBA Fair value of liabilities assumed $ – $ (1,180) $ – – – $ (1,180) – $ (21) – $ – – $ – $ (21) (1,617) 661 $ (661) 661 (2,228) (1) In connection with the acquisition of the Canadian operations of UnumProvident, we assumed UnumProvident’s policy liabilities and received assets with the equivalent fair value to support future payments. Royal Bank of Canada Annual Report 2006 154 Consolidated Financial Statements Pensions and other post-employment benefits The following table provides information on our defined benefit plans in addition to those disclosed in Note 20. Plan assets, benefit obligations and funded status Amounts recognized on the Consolidated Balance Sheets consist of: Prepaid pension benefit cost Accrued pension benefit expense Intangible asset Accumulated other comprehensive income (before taxes) Net amount recognized as at October 31 Accumulated benefit obligation (1) Pension plans Other post-employment plans 2006 2005 2006 2005 $ $ $ 682 (133) 21 95 665 6,277 $ $ $ $ 137 (300) 130 480 $ – (1,154) – – – (1,102) – – 447 $ (1,154) $ (1,102) 5,944 n.a. n.a. (1) For all plans where the accumulated benefit obligations exceeded the fair values of the plan assets, the accumulated benefit obligation and the fair value of the assets were $923 million (2005 – $5,265 million) and $789 million (2005 – $4,987 million), respectively. Hedging activities 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 effec- tiveness. 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 Other comprehensive income for the effective portion of changes in fair value of derivatives designated as cash flow hedges. The amounts recognized in Other comprehensive income 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) was reclassified to Net income during the year. A net loss of $26 million (2005 – $111 million) deferred in Accumulated other comprehensive income 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) 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 $502 million (2005 – $618 million) related to our net invest- ments in foreign operations, which were offset by gains of $270 million (2005 – $401 million) related to derivative and non-derivative instru- ments designated as hedges for such foreign currency exposures. The net foreign currency gains (losses) are recorded as a component of Other comprehensive income. Average assets, U.S. GAAP Domestic United States Other International 2006 2005 2004 Average assets % of total average assets Average assets % of total average assets Average assets % of total average assets $ 297,740 119,614 104,533 57% 23% 20% $ 277,442 97,002 101,961 58% 20% 22% $ 253,100 94,231 96,267 $ 521,887 100% $ 476,405 100% $ 443,598 57% 21% 22% 100% Future accounting changes Accounting for certain hybrid financial instruments On February 16, 2006, FASB issued FASB Statement No. 155, Accounting for Certain Hybrid Instruments – an amendment of FASB Statement No. 133 and 140 (FAS 155), which allows an entity to elect to measure certain hybrid financial instruments at fair value in their entirety, with changes in fair value recognized in earnings. The fair value election will eliminate the need to separately recognize certain derivatives embed- ded in hybrid financial instruments under FASB Statement No. 133, Accounting for Derivative Instruments & Hedging Activities. FAS 155 will be effective for us on November 1, 2006. Accounting for servicing financial assets On March 17, 2006, FASB issued 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 mea- sure its servicing rights at fair value and can choose to subsequently amortize the initial fair value over the term of the servicing rights, or remeasure them at fair value through income. The ability to remeasure servicing rights at fair value through income will eliminate the account- ing mismatch between the servicing rights and the related derivatives that would otherwise result in the absence of hedge accounting. FAS 156 will be effective for us on November 1, 2006. The implementation of these two standards is not expected to have a material impact on our consolidated financial position and results of operations. Guidance on accounting for income taxes On July 13, 2006, FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 (FIN 48), which provides additional guidance on how to recog- nize, measure, and disclose income tax benefits. FIN 48 will be effective for us on November 1, 2007. Royal Bank of Canada Annual Report 2006 Consolidated Financial Statements 155 Note 31 Reconciliation of Canadian and United States generally accepted accounting principles (continued) Accounting for defined benefit pension and other post-retirement plans On September 29, 2006, FASB issued 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). FAS 158 requires an entity to (i) recognize the overfunded or underfunded status of a benefit plan as an asset or liability in the balance sheet; (ii) recognize the existing unrecognized net gains and losses, unrecognized prior-service costs and credits, and unrecognized net transition assets or obligations in Other comprehensive income; and (iii) measure defined benefit plan assets and obligations as of the year- end balance sheet date. This statement is effective prospectively for us at the end of fiscal year 2007 in respect of recognition requirements mentioned in (i) and (ii) above, and for the end of the fiscal year 2009 in respect of measurement date changes mentioned in (iii) above. Accounting for deferred acquisition costs for insurance operations In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 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 changed from the replaced contract is accounted for as an extinguishment of the replaced contract, resulting in the release of deferred costs including unamortized deferred acquisition costs. This SOP 05-1 will be effective for us on November 1, 2007. Guidance for quantifying financial statement misstatements On September 13, 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SEC staff issued SAB 108 to address what they identified as diversity in practice whereby entities were using either an income statement approach or a balance sheet approach, but not both, when evaluating whether an error is material to an entity’s financial statements. SAB 108 requires that in quantifying and analyzing misstatements, both the income statement approach and the balance sheet approach should be used to evaluate the materiality of financial statement misstatements. SAB 108 will be effective for us on November 1, 2007. 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 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 the above standards on our consolidated financial position and results of operations. Note 32 Subsequent events On November 1, 2006, RBC Centura Bank announced that it had signed an agreement with AmSouth Bancorporation (AmSouth Bank) pursu- ant to which RBC Centura Bank will acquire 39 branches in Alabama owned by AmSouth Bank. On November 21, 2006, RBC Capital Markets announced that it had signed an agreement to acquire Daniels & Associates, L.P. (Daniels), a mergers and acquisitions advisor to the cable, telecom and broadcast industries. Both acquisitions are subject to regulatory approvals and other customary conditions. The acquisi- tions of branches from AmSouth Bank and Daniels are expected to close in the second and first quarter of 2007, respectively. Royal Bank of Canada Annual Report 2006 156 Consolidated Financial Statements Supplementary information Consolidated Balance Sheets As at October 31 (C$ millions) 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 Assets Cash and deposits with banks (1) Securities (1) Assets purchased under reverse repurchase agreements and securities borrowed Loans Residential mortgage Personal Credit cards Business and government $ 14,903 $ 10,238 $ 9,978 $ 6,013 $ 6,659 $ 6,244 $ 184,869 160,495 128,946 128,931 108,464 91,798 7,149 $ 16,591 $ 13,389 $ 18,390 $ 22,313 44,744 44,405 57,010 36,039 69,467 59,378 42,973 46,949 41,182 38,929 40,177 20,749 23,091 23,008 20,107 12,446 96,675 44,902 7,155 61,207 91,043 41,045 6,200 53,626 81,998 36,848 6,456 47,258 75,790 32,186 4,816 49,657 72,840 30,588 4,914 59,431 67,442 31,395 4,283 65,261 62,984 27,087 4,666 60,350 59,242 25,050 2,666 56,623 57,069 22,760 1,945 63,732 53,369 20,864 2,324 61,813 48,120 18,440 3,522 55,491 Allowance for loan losses 209,939 (1,409) 191,914 (1,498) 172,560 (1,644) 162,449 (2,055) 167,773 (2,203) 168,381 (2,278) 155,087 (1,871) 143,581 (1,884) 145,506 (2,026) 138,370 (1,769) 125,573 (1,875) 208,530 190,416 170,916 160,394 165,570 166,103 153,216 141,697 143,480 136,601 123,698 Other Customers’ liability under acceptances Derivative-related amounts Premises and equipment, net Goodwill Other intangibles Assets of operations held for sale (2) Other assets Liabilities and shareholders’ equity Deposits Personal Business and government Bank 9,108 37,729 1,818 4,304 642 7,074 38,834 1,708 4,203 409 6,184 38,897 1,738 4,280 521 5,943 35,616 1,648 4,356 566 8,051 30,258 1,653 5,004 665 9,923 27,240 1,602 4,919 619 11,628 19,155 1,249 648 208 9,257 15,151 1,320 611 – 10,620 30,413 1,872 551 – 10,561 14,776 1,696 607 – 7,423 12,994 1,785 335 – 82 15,417 263 12,908 2,457 15,356 3,688 11,510 – 10,221 – 10,314 – 6,271 – 5,922 – 6,661 – 5,997 – 5,760 69,100 65,399 69,433 63,327 55,852 54,617 39,159 32,261 50,117 33,637 28,297 $ 536,780 $ 469,521 $ 426,222 $ 399,847 $ 375,474 $ 358,939 $ 289,740 $ 270,650 $ 274,399 $ 244,774 $ 231,498 $ 114,040 $ 111,618 $ 111,256 $ 106,709 $ 101,892 $ 101,381 $ 89,632 $ 87,359 $ 85,910 $ 86,106 $ 90,774 47,799 107,141 23,244 24,925 76,107 17,988 119,581 22,003 64,368 22,755 160,593 34,649 93,618 19,646 86,223 14,315 129,860 22,576 133,823 25,880 189,140 40,343 Other Acceptances Obligations related to securities sold short Obligations related to assets sold under repurchase agreements and securities loaned Derivative-related amounts Insurance claims and policy benefit liabilities Liabilities of operations held for sale (2) Other liabilities Subordinated debentures Trust capital securities Preferred share liabilities Non-controlling interest in subsidiaries Shareholders’ equity Preferred shares Common shares Contributed surplus Retained earnings Treasury shares – preferred – common Net foreign currency translation adjustments 343,523 306,860 270,959 259,145 243,476 233,447 202,896 187,897 180,005 173,229 161,817 9,108 7,074 6,184 5,943 8,051 9,923 11,628 9,257 10,620 10,561 7,423 38,252 32,391 25,005 22,855 19,110 16,443 13,419 17,885 14,404 11,152 8,331 41,103 42,094 23,381 42,592 26,473 42,201 24,496 37,775 24,056 32,137 22,672 28,646 9,895 18,574 11,093 15,219 13,756 29,370 9,669 14,732 16,835 13,449 7,337 7,117 6,488 4,775 2,407 2,268 144 113 427 – 91 32 22,649 40 18,408 62 20,172 50 17,850 – 19,405 – 19,417 – 13,128 – 11,872 – 9,339 – 10,176 – 10,428 160,575 131,003 126,585 113,744 105,166 99,369 66,788 65,439 77,916 56,290 56,557 7,103 1,383 298 8,167 1,400 300 8,116 2,300 300 6,243 2,300 300 6,614 1,400 6,513 5,825 4,596 4,087 4,227 3,602 1,400 650 – – – – 989 1,315 1,585 1,562 1,844 1,484 1,452 1,775 1,944 58 40 35 45 40 103 499 531 108 1,050 7,196 292 15,771 (2) (180) 700 7,170 265 13,704 (2) (216) 532 6,988 169 12,065 – (294) 532 7,018 85 11,333 – – 556 6,979 78 10,235 – – 709 6,940 33 9,206 – – 452 3,076 – 8,464 – – 447 3,065 – 7,579 – – 300 2,925 – 6,857 – – 300 2,907 – 5,728 – – 300 2,876 – 4,809 – – (2,004) (1,774) (1,556) (893) (54) (38) (36) (38) (34) (29) (23) 22,123 19,847 17,904 18,075 17,794 16,850 11,956 11,053 10,048 8,906 7,962 $ 536,780 $ 469,521 $ 426,222 $ 399,847 $ 375,474 $ 358,939 $ 289,740 $ 270,650 $ 274,399 $ 244,667 $ 231,498 (1) (2) As the information is not reasonably determinable, amounts for years prior to 2001 have not been fully restated to reflect the reclassification of certificates of deposits. Relates to assets and liabilities of discontinued operations (RBC Mortgage Company). As the information is not reasonably determinable, amounts for years prior to 2003 have not been restated to reflect the presentation of assets and liabilities of operations held for sale. Royal Bank of Canada Annual Report 2006 Supplementary information 157 Interest income Loans Securities Assets purchased under reverse repurchase agreements and securities borrowed Deposits with banks Consolidated Statements of Income For the year ended October 31 (C$ millions, except per share amounts) 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 $ 12,708 $ 10,790 $ 6,155 4,583 9,535 $ 3,572 9,900 $ 10,394 $ 12,001 $ 11,538 $ 10,394 $ 10,474 $ 3,025 1,955 3,175 2,832 2,356 3,505 9,354 $ 2,159 9,490 2,445 2,827 480 1,354 231 656 103 873 101 725 156 1,258 337 1,078 577 893 513 1,169 673 568 971 366 891 22,170 16,958 13,866 13,899 14,450 17,101 16,025 14,156 14,271 13,052 13,192 Interest expense Deposits Other liabilities Subordinated debentures 10,708 4,281 419 6,946 2,800 442 15,408 10,188 Net interest income 6,762 6,770 Non-interest income Insurance premiums, investment and fee income Trading revenue Investment management and custodial fees Securities brokerage commissions Mutual fund revenue Service charges Underwriting and other advisory fees Card service revenue Foreign exchange revenue, other than trading Securitization revenue Credit fees Gain on sale of investment account securities Other 3,348 2,574 1,335 1,243 1,242 1,216 1,024 496 438 257 241 88 373 3,270 1,594 1,255 1,163 962 1,153 1,026 579 407 285 187 85 448 5,142 1,897 429 7,468 6,398 2,870 1,563 1,126 1,166 850 1,089 918 555 331 200 198 20 518 5,452 1,735 376 7,563 6,336 5,709 1,562 406 8,712 1,868 410 9,057 1,551 344 7,677 10,990 10,952 6,773 6,111 5,073 7,636 1,291 286 9,213 4,943 7,732 1,296 339 9,367 4,904 6,548 1,251 384 8,183 4,869 7,115 1,238 322 8,675 4,517 2,356 1,908 1,098 1,031 673 1,122 813 518 279 165 227 31 431 2,043 1,689 1,153 1,187 723 1,088 755 496 276 174 223 (111) 623 1,824 1,770 1,074 1,000 692 920 573 458 303 123 237 (130) 921 973 1,594 737 1,106 835 841 624 778 643 420 299 115 212 (16) 185 629 625 556 708 403 362 243 222 189 27 250 578 748 602 549 537 664 369 305 218 218 183 342 146 452 606 401 756 354 690 416 332 211 – 169 35 222 337 368 317 491 241 701 273 282 165 – 153 105 115 Non-interest income 13,875 12,414 11,404 10,652 10,319 9,765 7,503 6,057 5,459 Total revenue 20,637 19,184 17,802 16,988 17,092 15,876 12,576 11,000 10,363 Provision for credit losses 429 455 346 721 1,065 1,119 691 760 575 4,644 9,513 380 3,548 8,065 440 Insurance policyholder benefits, claims and acquisition expense Non-interest expense Human resources Equipment Occupancy Communications Professional fees Outsourced item processing Amortization of goodwill Amortization of other intangibles Other Business realignment charges Goodwill impairment Income from continuing operations before income taxes Income taxes Net income before non-controlling interest Non-controlling interest in net income of subsidiaries – – 6,204 1,403 4,801 44 2,509 2,625 2,124 1,696 1,535 1,344 687 530 438 346 266 7,340 957 792 687 628 298 – 76 717 6,736 960 749 632 529 296 – 50 1,405 6,701 906 765 672 474 294 – 69 952 6,297 882 721 707 444 292 – 71 751 6,315 893 759 768 416 306 – 72 891 11,495 11,357 10,833 10,165 10,420 45 – 177 – – – – – 5,723 807 704 673 409 303 210 36 852 9,717 – 38 4,651 679 556 695 267 – 76 11 646 7,581 – – 4,013 677 564 699 298 – 66 – 743 7,060 – – 3,594 585 508 665 262 – 62 – 723 6,399 – – 3,365 605 559 587 228 – 59 – 650 6,053 – – 2,851 492 507 523 165 – 38 – 536 5,112 – – 4,702 1,278 4,322 1,287 4,406 1,439 4,072 1,365 3,658 1,340 3,617 1,445 2,650 1,015 2,951 1,175 2,734 1,090 2,247 880 3,424 3,035 2,967 2,707 2,318 2,172 1,635 1,776 1,644 1,367 (13) 12 12 5 11 7 8 76 77 49 Net income from continuing operations Net income (loss) from discontinued operations 4,757 3,437 3,023 2,955 2,702 2,307 2,165 1,627 1,700 1,567 1,318 (29) (50) (220) 13 n.a. n.a. n.a. n.a. n.a. n.a. n.a. Net income $ 4,728 $ 3,387 $ 2,803 $ 2,968 $ 2,702 $ 2,307 $ 2,165 $ 1,627 $ 1,700 $ 1,567 $ 1,318 Preferred dividends Net gain on redemption of preferred shares Net income available to common shareholders (60) – (42) 4 (31) – (31) – (38) – (31) – (25) – (27) – (21) – (19) – (32) – $ 4,668 $ 3,349 $ 2,772 $ 2,937 $ 2,664 $ 2,276 $ 2,140 $ 1,600 $ 1,679 $ 1,548 $ 1,286 Average number of common shares (in thousands) (1) Basic earnings per share (in dollars) $ Basic earnings per share from continuing operations (in dollars) $ Basic earnings (loss) per share from discontinued operations (in dollars) $ Average number of diluted common shares (in thousands) (1) Diluted earnings per share (in dollars) $ Diluted earnings per share from continuing operations (in dollars) $ Diluted earnings (loss) per share from discontinued operations (in dollars) $ 1,279,956 1,283,433 1,293,465 1,324,159 1,345,143 1,283,031 1,212,777 3.65 $ 2.61 $ 2.14 $ 2.22 $ 1.98 $ 1.77 $ 1.77 $ 1,252,316 1,234,648 1,235,624 1,256,484 1.02 1.36 $ 1.25 $ 1.28 $ 3.67 $ 2.65 $ 2.31 $ 2.21 $ 1.98 $ 1.77 $ 1.77 $ 1.28 $ 1.36 $ 1.25 $ 1.02 (.02) $ (.04) $ (.17) $ .01 n.a. n.a. n.a. n.a. n.a. n.a. n.a. 1,299,785 1,304,680 1,311,016 1,338,032 1,356,241 1,294,432 1,219,730 1,264,610 1,267,253 3.59 $ 2.57 $ 2.11 $ 2.20 $ 1.96 $ 1.76 $ 1.76 $ 1.27 $ 1.34 $ 1,264,103 1,257,247 1.02 1.23 $ 3.61 $ 2.61 $ 2.28 $ 2.19 $ 1.96 $ 1.76 $ 1.76 $ 1.27 $ 1.34 $ 1.23 $ 1.02 (.02) $ (.04) $ (.17) $ .01 n.a. n.a. n.a. n.a. n.a. n.a. Dividends per share (in dollars) (1) $ 1.44 $ 1.18 $ 1.01 $ .86 $ .76 $ .69 $ .57 $ .47 $ .44 $ .38 $ (1) n.a. The average number of common shares, average number of diluted common shares, basic and diluted earnings per share, as well as dividends per share, have been adjusted retroactively for the stock dividend paid on April 6, 2006. Refer to Note 25. not available Royal Bank of Canada Annual Report 2006 158 Supplementary information n.a. .34 Consolidated Statements of Changes in Shareholders’ Equity For the year ended October 31 (C$ millions) Preferred shares Balance at beginning of year Issued Redeemed for cancellation Translation adjustment 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 (1) $ 700 $ 600 (250) – 532 $ 300 (132) – 532 $ – – – 556 $ – – (24) 709 $ – (150) (3) 452 $ 250 – 7 447 $ – – 5 300 $ 296 (150) 1 300 $ – – – 300 $ – – – 535 – (237) 2 300 Balance at end of year 1,050 700 532 532 556 709 452 447 300 300 Common shares Balance at beginning of year Issued Purchased for cancellation Balance at end of year Contributed surplus Balance at beginning of year Renounced stock appreciation rights Stock-based compensation awards Gain on redemption of preferred shares Reclassified amounts Initial adoption of AcG-15, Consolidation of Variable Interest Entities Other Balance at end of year Retained earnings Balance at beginning of year Net income Preferred share dividends Common share dividends Premium paid on common shares purchased for cancellation Issuance costs and other Cumulative effect of initial adoption of Employee Future Benefits Cumulative effect of adopting AcG-17, Equity-Linked Deposit Contracts 7,170 127 (101) 7,196 6,988 214 (32) 7,018 127 (157) 6,979 193 (154) 6,940 191 (152) 3,076 3,976 (112) 3,065 109 (98) 7,170 6,988 7,018 6,979 6,940 3,076 2,925 192 (52) 3,065 2,907 18 – 2,925 2,876 69 (38) 2,910 – (34) 2,907 2,876 265 169 (2) (18) – – – 47 292 (6) 26 7 – 54 15 265 85 – 56 – 34 – (6) 169 78 – 7 – – – – 33 31 14 – – – – – – 33 – – – – 85 78 33 13,704 4,728 (60) (1,847) 12,065 3,387 (42) (1,512) 11,333 2,803 (31) (1,303) 10,235 2,968 (31) (1,137) (743) (11) (194) – (735) – (698) (4) – – – – – (2) – – 9,206 2,702 (38) (1,022) (612) (1) – – 8,464 2,307 (31) (897) (397) (19) (221) – – – – – – – – – 7,579 2,165 (25) (689) (562) (4) – – – – – – – – – – 6,857 1,627 (27) (588) (281) (9) – – – – – – – – – – 5,728 1,700 (21) (543) – (7) – – – – – – – – – – 4,809 1,567 (19) (469) (160) – – – – – – – – – – – 4,077 1,318 (32) (418) (136) – – – Balance at end of year 15,771 13,704 12,065 11,333 10,235 9,206 8,464 7,579 6,857 5,728 4,809 Treasury shares – preferred Balance at beginning of year Sales Purchases Balance at end of year Treasury shares – common Balance at beginning of year Sales Purchases Reclassified amounts Initial adoption of AcG-15, Consolidation of Variable Interest Entities Balance at end of year Net foreign currency translation adjustments Balance at beginning of year Unrealized foreign currency translation gain (loss) Foreign currency gain (loss) from hedging activities (2) 51 (51) (2) (216) 193 (157) – – (180) – – (2) (2) (294) 179 (47) – (54) (216) – – – – – 248 (238) (304) – (294) – – – – – – – – – – (1,774) (1,556) (893) (54) (499) (619) (1,341) (2,988) 269 401 678 2,149 Balance at end of year (2,004) (1,774) (1,556) (893) – – – – – – – – – – (38) (59) 43 (54) – – – – – – – – – – (36) 473 (475) (38) – – – – – – – – – – (38) (2) 4 (36) – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – (34) (29) (205) 164 201 (38) (169) (34) (23) 129 (135) (29) – – – – – – – – – – (20) (12) 9 (23) Shareholders’ equity at end of year $ 22,123 $ 19,847 $ 17,904 $ 18,075 $ 17,794 $ 16,850 $ 11,956 $ 11,053 $ 10,048 $ 8,906 $ 7,962 (1) Retained earnings at the beginning of 1996 was reduced by $75 million as a result of the adoption of the Impaired Loans accounting standard. Royal Bank of Canada Annual Report 2006 Supplementary information 159 Financial highlights (C$ millions, except per share and percentage amounts) Performance ratios Return on common equity Return on assets Return on assets after preferred dividends Net interest margin (1) Non-interest income as a % of total revenue Average balances and year-end off-balance sheet data Averages (2) Assets Assets from continuing operations Loans, acceptances and reverse repurchase agreements Deposits Common equity Total equity Assets under administration – 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 23.5% .94 .93 1.35 18.0% .76 .75 1.52 15.6% .67 .66 1.53 16.7% .76 .75 1.63 15.8% .74 .73 1.86 16.4% .71 .70 1.89 19.8% .77 .76 1.80 15.6% .60 .59 1.83 18.4% .65 .64 1.88 19.3% .65 .65 2.03 17.6% .64 .63 2.20 67.2% 64.7% 64.1% 62.7% 60.4% 61.5% 59.7% 55.1% 52.7% 48.8% 44.0% $ 502,300 $ 447,100 $ 421,400 $ 390,700 $ 364,000 $ 322,900 $ 281,900 $ 269,900 $ 261,300 $ 239,500 $ 204,900 $ 502,100 $ 445,300 $ 418,200 $ 387,700 $ 364,000 $ 322,900 $ 281,900 $ 269,900 $ 261,300 $ 239,500 $ 204,900 261,911 323,299 19,898 20,709 230,484 288,197 18,592 19,451 215,733 268,202 17,790 18,622 209,161 250,777 17,551 18,761 208,184 240,397 16,809 18,522 196,861 218,425 13,843 15,916 181,240 193,762 10,814 12,789 177,052 184,796 10,264 12,475 178,822 178,688 9,107 11,078 154,809 166,249 8,003 9,744 130,656 147,391 7,320 9,265 RBC 525,800 1,778,200 1,593,900 1,483,800 1,365,900 1,342,500 1,175,200 967,800 829,200 783,300 522,100 Assets under administration – RBC Dexia IS Assets under management Capital ratios (3) Tier 1 capital Total capital Total risk-adjusted assets Tier 1 capital ratio Total capital ratio Common share information Shares outstanding (in thousands) End of year Average basic Average diluted Dividends per share Book value per share Common share price (RY on TSX) – High (4) Low (4) Close Price/earnings multiple (5) Dividend yield (6) Dividend payout ratio (7) Number of Employees (8) Automated banking machines Bank branches (9) Canada U.S. and International 1,893,000 143,100 – 118,800 – 102,900 – 94,400 – 93,300 – 100,000 – 92,300 – 81,600 – 73,400 – 67,700 – 51,200 $ 21,478 $ 26,664 223,709 9.6% 11.9 16,272 $ 18,901 $ 25,813 197,004 9.6% 22,733 183,409 8.9% 16,259 $ 21,374 166,911 9.7% 13.1 12.4 12.8 15,380 $ 21,012 165,559 9.3% 12.7 14,851 $ 20,171 171,047 8.7% 11.8 13,567 $ 19,044 158,364 8.6% 12.0 12,026 $ 16,698 149,078 8.1% 11.2 11,593 $ 16,480 157,064 7.4% 10.5 10,073 $ 14,705 147,672 6.8% 10.0 9,037 12,069 128,163 7.0% 9.4 1,280,890 1,279,956 1,299,785 1,293,502 1,289,496 1,312,043 1,330,514 1,283,433 1,293,465 1,345,143 1,304,680 1,311,016 1,338,032 1,356,241 1,324,159 1,348,042 1,204,796 1,235,535 1,283,031 1,212,777 1,252,316 1,234,648 1,294,432 1,219,730 1,264,610 1,267,253 $ 1.44 $ 1.18 $ 1.01 $ .86 $ .76 $ .69 $ 16.52 14.89 13.57 13.37 12.96 11.97 .57 $ 9.55 .47 $ 8.58 1,235,162 1,233,342 1,242,118 1,235,624 1,256,484 1,264,103 1,257,247 .34 .38 $ 6.17 .44 $ 7.89 6.98 51.49 41.29 49.80 12.9 3.1% 40 60,858 4,232 1,117 326 43.34 30.45 41.67 14.4 3.2% 45 32.95 29.02 31.70 14.7 3.3% 47 32.50 26.63 31.74 13.4 2.9% 39 29.45 22.53 27.21 13.3 2.9% 38 26.63 20.80 23.40 13.5 2.9% 39 24.44 13.63 24.15 10.8 3.0% 32 21.06 14.83 15.86 14.2 2.6% 37 23.05 14.38 17.78 14.0 2.4% 32 19.11 11.00 18.84 12.2 2.5% 30 11.10 7.44 11.08 9.0 3.6% 33 60,012 4,277 61,003 4,432 60,812 4,469 59,549 4,572 57,568 4,697 49,232 4,517 51,891 4,585 51,776 4,317 48,816 4,248 46,205 4,215 1,104 315 1,098 317 1,104 282 1,117 278 1,125 283 1,333 306 1,410 99 1,422 106 1,453 105 1,493 103 Based on methods intended to approximate the average of the daily balances for the period. Calculated using guidelines issued by the Office of the Superintendent of Financial Institutions Canada. Intra-day high and low share prices. Average of high and low common share price divided by diluted earnings per share. (1) Net interest income as a percentage of average assets from continuing operations. (2) (3) (4) (5) (6) Dividends per common share divided by the average of high and low share price. Common dividends as a percentage of net income after preferred dividends. (7) (8) On a full-time equivalent basis. (9) Bank branches which provide full or limited banking services dealing directly with clients. Bank branches prior to 2001 are reported on the basis of service delivery units. Royal Bank of Canada Annual Report 2006 160 Supplementary information Glossary Acceptances A bill of exchange or negotiable instrument drawn by the borrower for payment at matu- rity 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. Adjusted operating leverage The difference between revenue growth rate (as adjusted) and non-interest expense growth rate (as adjusted). Revenue is based on a taxable equivalent basis, excluding VIEs, accounting adjustments related to the new Financial Instruments Standard and Insurance- related revenue, while Non-interest expense excludes Insurance-related expense. Allowance for credit losses The amount deemed adequate by manage- ment 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, divided by total regulatory capital. Assets under administration (AUA) Assets administered by us which are benefi- cially owned by clients and are therefore not reported on the Consolidated Balance Sheets. Services provided in respect of assets under administration are of an administrative nature, including safekeeping, collecting investment income, settling purchase and sale transac- tions, and record keeping. Assets under management (AUM) Assets managed by us which are beneficially owned by clients and are therefore not reported on the Consolidated Balance Sheets. Services provided in respect of assets under management include the selection of invest- ments and the provision of investment advice. Assets under management may also be administered by the financial institution. Average balances Average balances are calculated using meth- ods intended to approximate the average of the daily balances of the period. Average earning assets The average carrying value of deposits with banks, securities, assets purchased under reverse repurchase agreements and certain securities borrowed, and loans based on daily balances for the period ending October 31 in each fiscal year. Basis point (bp) One one-hundredth of a percentage point (.01%). Beta The measure of a security’s volatility relative to a market index. Canadian GAAP Canadian generally accepted accounting principles. Capital ratio The percentage of risk-adjusted assets supported by capital, using the guidelines of the Office of the Superintendent of Financial Institutions Canada based on stan- dards issued by the Bank for International Settlements and Canadian GAAP financial information. 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: cash, highly rated securities, property, inven- tory, equipment, receivables, etc. Collateralized Debt Obligation (CDO) An investment-grade security backed by a pool of bonds, loans and/or any other type of debt instruments. Commercial clients Generally, private companies with revenue in excess of $20 million and less than $1 billion. Typically, clients with revenue of less than $100 million are served in Canada by our RBC Canadian Personal and Business segment and in the U.S. by RBC Centura in our RBC U.S. and International Personal and Business seg- ment. Corporate and larger commercial clients with frequent need to access capital markets and more sophisticated financing require- ments are served by our RBC Capital Markets segment. Commitments to extend credit 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. Cost of capital Management’s estimate of its weighted average cost of equity and debt capital. De novo A newly opened bank branch, as opposed to a bank branch acquired through an acquisition. Derivative A contract between two parties where pay- ments between the parties are dependent upon the movements in price of an underlying asset, 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 (for example, 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 Net income less preferred share dividends, divided by the average number of shares outstanding. Earnings per share (EPS), diluted Net income less preferred share dividends, divided by the average number of shares out- standing, adjusted for the dilutive effects of stock options and other convertible securities. Economic capital 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. Royal Bank of Canada Annual Report 2006 Glossary 161 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. 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 writ- ten off after payments are 180 days past due. Innovative capital instruments Our innovative capital instruments are trans- ferable trust units issued by the RBC Capital Trust and RBC Capital Trust II special purpose entities. Innovative capital can comprise up to 15% of net Tier 1 capital with an additional 3% eligible for Tier 2B capital. 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 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. Normal course issuer bid (NCIB) A repurchase of our own shares for cancella- tion through a stock exchange; it is subject to the various rules of the relevant exchanges and securities commissions. Notional amount The contract amount used as a reference point to calculate payments for derivatives. Off-balance sheet financial instruments A variety of products offered to clients, which fall into two broad categories: (i) credit related arrangements, which generally provide clients with liquidity protection, and (ii) derivatives, which are defined on the previous page. Royal Bank of Canada Annual Report 2006 162 Glossary Office of the Superintendent of Financial Institutions Canada (OSFI) The primary regulator of federally chartered financial institutions and federally adminis- tered 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. Qualifying special purposes entities (QSPE) Legal entities that are demonstrably distinct from the transferor, have limited and specified permitted activities, have defined asset hold- ings and may only sell or dispose of selected assets in automatic response to specified conditions. 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. 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 differ- ent risks that expose them to possible losses. These risks include credit risk, market risk, liquidity and funding risk, insurance risk, operational risk, reputation risk, strategic risk, regulatory and legal risk, and competitive, systemic and environmental risk. Risk-adjusted assets Used in the calculation of risk-based capital ratios. The face value of assets is discounted using risk-weighting factors in order to reflect a comparable risk per dollar among all types of assets. The risk inherent in off-balance sheet instruments is also recognized, first by deter- mining 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 pre- arranged contract to a borrower for a fee. The borrower must fully 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 intermediary bears no risk of loss. For transactions in which the intermediary provides an indemnification, risk of loss occurs 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 securi- ties backed by these assets. Special purpose entities (SPEs) SPEs are 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 organi- zation. 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. Taxable equivalent basis (teb) A measure that increases Net interest income from certain tax-advantaged sources (in our case, Canadian taxable Corporate dividends) to their tax equivalent value, making it comparable to income from taxable sources. There is an offsetting adjustment in the tax provision, thereby generating the same after-tax net income as reported under GAAP. Trust capital securities (RBC TruCS) Transferable trust units issued by RBC Capital Trust or RBC Capital Trust II for the purpose of raising innovative Tier 1 capital. U.S. GAAP U.S. generally accepted accounting principles. Value-At-Risk (VAR) A generally accepted risk-measurement concept that uses statistical models to esti- mate within a given level of confidence the maximum loss in market value the bank would experience in its trading portfolio from an adverse one-day movement in market rates and prices. Variable interest entity (VIE) A variable interest entity is an entity which does not have sufficient equity at risk to finance its activities without additional subor- dinated financial support or where the holders of the equity at risk lack the characteristics of a controlling financial interest. Directors and executive officers Directors W. Geoffrey Beattie (2001) Toronto, Ontario President and Chief Executive Officer The Woodbridge Company Limited Deputy Chairman The Thomson Corporation George A. Cohon, O.C., O.Ont. (1988) Toronto, Ontario Founder McDonald’s Restaurants of Canada Limited Douglas T. Elix, A.O. (2000) Ridgefield, Connecticut Senior Vice-President and Group Executive Sales & Distribution IBM Corporation John T. Ferguson, F.C.A. (1990) Edmonton, Alberta Chairman of the Board Princeton Developments Ltd. Group executive Peter Armenio Group Head, RBC U.S. and International Personal and Business Elisabetta Bigsby Group Head, Human Resources and Transformation The Hon. Paule Gauthier, P.C., O.C., O.Q., Q.C. (1991) Quebec, Quebec Senior Partner Desjardins Ducharme L.L.P. ATTORNEYS Timothy J. Hearn (2006) Calgary, Alberta Chairman, President and Chief Executive Officer Imperial Oil Limited Alice D. Laberge (2005) Vancouver, British Columbia Company Director Jacques Lamarre, O.C. (2003) Outremont, Quebec President and Chief Executive Officer SNC-Lavalin Group Inc. Brandt C. Louie, F.C.A. (2001) West Vancouver, British Columbia President and Chief Executive Officer H.Y. Louie Co. Limited Chairman and Chief Executive Officer London Drugs Limited Michael H. McCain (2005) Toronto, Ontario President and Chief Executive Officer Maple Leaf Foods Inc. Gordon M. Nixon (2001) Toronto, Ontario President and Chief Executive Officer Royal Bank of Canada David P. O’Brien (1996) Calgary, Alberta Chairman of the Board Royal Bank of Canada Chairman of the Board EnCana Corporation Robert B. Peterson (1992) Toronto, Ontario Company Director J. Pedro Reinhard (2000) Key Biscayne, Florida Company Director Cecil W. Sewell, Jr. (2001) Stuart, Florida Chairman RBC Centura Banks, Inc. Kathleen P. Taylor (2001) Toronto, Ontario President, Worldwide Business Operations Four Seasons Hotels Inc. Victor L. Young, O.C. (1991) St. John’s, Newfoundland and Labrador Company Director The date appearing after the name of each director indicates the year in which the individual became a director. Martin J. Lippert Group Head, Global Technology and Operations Gordon M. Nixon President and Chief Executive Officer Barbara G. Stymiest Chief Operating Officer Charles M. Winograd Group Head, RBC Capital Markets W. James Westlake Group Head, RBC Canadian Personal and Business Royal Bank of Canada Annual Report 2006 Directors and executive officers 163 Principal subsidiaries Principal subsidiaries (1) Royal Bank Mortgage Corporation (4) Royal Mutual Funds Inc. RBC Capital Trust RBC Dominion Securities Limited (4) RBC Dominion Securities Inc. RBC Investment Services (Asia) Limited RBC Sec Australia Pty Limited Royal Bank Holding Inc. Royal Trust Corporation of Canada The Royal Trust Company RBC Insurance Holding Inc. RBC General Insurance Company RBC Life Insurance Company RBC Travel Insurance Company RBC Direct Investing Inc. RBC Asset Management Inc. RBC Private Counsel Inc. R.B.C. Holdings (Bahamas) Limited RBC Caribbean Investment Limited Royal Bank of Canada Insurance Company Limited Finance Corporation of Bahamas Limited Royal Bank of Canada Trust Company (Bahamas) Limited Investment Holdings (Cayman) Limited RBC (Barbados) Funding Ltd. Royal Bank of Canada (Caribbean) Corporation RBC Capital Markets Arbitrage SA RBC Holdings (USA) Inc. (2) RBC USA Holdco Corporation (2) RBC Dain Rauscher Corp. (2) RBC Dain Rauscher Inc. RBC Capital Markets Corporation RBC Holdings (Delaware) Inc. (5) Prism Financial Corporation (5) RBC Trust Company (Delaware) Limited RBC Insurance Holding (USA) Inc. Liberty Life Insurance Company Royal Bank of Canada (Asia) Limited RBC Centura Banks, Inc. (5) RBC Centura Bank Royal Bank of Canada Financial Corporation RBC Finance B.V. Royal Bank of Canada Holdings (U.K.) Limited Royal Bank of Canada Europe Limited Royal Bank of Canada Investment Management (U.K.) Limited Royal Bank of Canada Trust Corporation Limited RBC Asset Management UK Limited RBC Holdings (Channel Islands) Limited RBC Trustees (Guernsey) Limited Royal Bank of Canada (Channel Islands) Limited Royal Bank of Canada Trustees (Jersey) Limited Royal Bank of Canada Investment Management (Guernsey) Limited Royal Bank of Canada Fund Services (Jersey) Limited Royal Bank of Canada Offshore Fund Managers Limited Royal Bank of Canada Trust Company (Asia) Limited Royal Bank of Canada Trust Company (Cayman) Limited Royal Bank of Canada Trust Company (International) Limited Regent Capital Trust Corporation Limited RBC Regent Fund Managers Limited Royal Bank of Canada Trustees Limited Royal Bank of Canada Trust Company (Jersey) Limited Abacus Financial Services Group Limited RBC Reinsurance (Ireland) Limited Royal Bank of Canada (Suisse) Roycan Trust Company S.A. RBC Investment Management (Asia) Limited RBC Capital Markets (Japan) Limited Principal office address (2) Montreal, Quebec, Canada Toronto, Ontario, Canada Toronto, Ontario, Canada Toronto, Ontario, Canada Toronto, Ontario, Canada Hong Kong, China Sydney, Australia Toronto, Ontario, Canada Toronto, Ontario, Canada Montreal, Quebec, Canada Mississauga, Ontario, Canada Mississauga, Ontario, Canada Mississauga, Ontario, Canada Mississauga, Ontario, Canada Toronto, Ontario, Canada Toronto, Ontario, Canada Toronto, Ontario, Canada Nassau, Bahamas George Town, Grand Cayman St. Michael, Barbados Nassau, Bahamas Nassau, Bahamas George Town, Grand Cayman St. Michael, Barbados St. Michael, Barbados Luxembourg New York, New York, U.S. New York, New York, U.S. Minneapolis, Minnesota, U.S. Minneapolis, Minnesota, U.S. New York, New York, U.S. Wilmington, Delaware, U.S. Dover, Delaware, U.S. Wilmington, Delaware, U.S. Wilmington, Delaware, U.S. Greenvillle, South Carolina, U.S. Singapore, Singapore Rocky Mount, North Carolina, U.S. Rocky Mount, North Carolina, U.S. St. Michael, Barbados Amsterdam, Netherlands London, England London, England London, England London, England London, England Guernsey, Channel Islands Guernsey, Channel Islands Guernsey, Channel Islands Jersey, Channel Islands Guernsey, Channel Islands Jersey, Channel Islands Guernsey, Channel Islands Hong Kong, China George Town, Grand Cayman Jersey, Channel Islands Jersey, Channel Islands Jersey, Channel Islands Jersey, Channel Islands Jersey, Channel Islands Jersey, Channel Islands Dublin, Ireland Geneva, Switzerland Geneva, Switzerland Hong Kong, China St. Michael, Barbados Carrying value of voting shares owned by the bank (3) $ 1,104 8 1,052 2,114 16,414 3,805 3 2,541 9 13 (1) (2) (3) (4) (5) The bank owns 100% of the voting shares of each subsidiary except Finance Corporation of Bahamas Limited (75%). Each subsidiary is incorporated under the laws of the state or country in which the principal office is situated, except for RBC Holdings (USA) Inc., RBC USA Holdco Corporation and RBC Dain Rauscher Corp. which are incorporated under the laws of the state of Delaware, U.S. The carrying value (in millions of dollars) of voting shares is stated as the bank’s equity in such investments. The subsidiaries have outstanding non-voting shares of which the bank, directly or indirectly, owns 100%. RBC Holdings (Delaware) Inc. owns 3.70% and Prism Financial Corporation owns 6.25% of RBC Centura Banks, Inc. Royal Bank of Canada Annual Report 2006 164 Principal subsidiaries Vision Values Strategic goals • Always earning the right to be • Excellent service to clients our clients’ first choice and each other • Working together to succeed • Personal responsibility for high performance • To be the undisputed leader in financial services in Canada • To build on our strengths in banking, wealth management and capital markets in the United States • Diversity for growth and • To be a premier provider innovation • Trust through integrity in everything we do of selected global financial services Financial highlights (C$ millions, except per share and percentage amounts) Operating performance Total revenue Provision for credit losses Non-interest expense Net income Return on common equity (ROE) Diluted earnings per share 2006 2005 2004 $ 20,637 429 11,495 4,728 23.5% 3.59 $ $ 19,184 455 11,357 3,387 18.0% 2.57 $ $ 17,802 346 10,833 2,803 15.6% 2.11 $ 2006 vs. 2005 Increase (decrease) $ $ 1,453 8% (26) (6)% 138 1% 1,341 40% 550 bps n.m. 1.02 40% RBC Canadian Personal and Business (C$ millions, except percentage amounts) Total revenue Net income Return on equity (ROE) Average loans and acceptances Average deposits Assets under administration Assets under management 2006 2005 2004 $ 13,381 $ 12,499 $ 11,213 2,043 24.7% 145,300 133,700 157,300 58,700 2,794 31.5% 180,500 145,700 213,200 89,700 2,304 27.1% 161,500 138,800 180,300 72,100 The businesses in RBC Canadian Personal and Business continued to strengthen our leadership position in most major product categories by expanding our distribution network, enhancing our products and services, better meeting our client needs and deepening our client relationships. 2006 vs. 2005 Increase (decrease) $ 882 7% 490 21% 440 bps n.m. 19,000 12% 6,900 5% 32,900 18% 17,600 24% 9.6% 11.9% $ 223,709 9.6% 13.1% $ 197,004 8.9% 12.4% $ 183,409 – bps n.m. (120)bps n.m. $ 26,705 14% RBC U.S. and International Personal and Business Capital Tier 1 capital ratio Total capital ratio Risk-adjusted assets Key drivers Total loans (before allowance for loan losses) Total deposits Total assets Assets under management Assets under administration (1) Common share information Share price High Low Close Dividends declared per share Book value per share Market capitalization ($ millions) $ 209,939 343,523 536,780 143,100 525,800 $ 191,914 306,860 469,521 118,800 417,100 $ 172,560 270,959 426,222 102,900 391,000 $ 18,025 9% 36,663 12% 67,259 14% 24,300 21% 108,700 26% $ 51.49 41.29 49.80 1.44 16.52 63,788 $ 43.34 30.45 41.67 1.18 14.89 53,894 $ 32.95 29.02 31.70 1.01 13.57 40,877 $ 8.15 19% 10.84 36% 8.13 20% .26 22% 1.63 11% 9,894 18% Excluding Institutional & Investor Services (IIS) assets that were contributed to the joint venture RBC Dexia Investor Services on January 2, 2006. (1) n.m. not meaningful (C$ millions, except percentage amounts) Total revenue Net income Return on equity (ROE) 2006 2005 2004 2006 vs. 2005 Increase (decrease) $ 2,872 $ 444 13.6% 2,728 $ 387 11.8% 2,702 $ 214 5.4% 144 5% 57 15% 180 bps n.m. (US$ millions, except percentage amounts) 2006 2005 2004 2006 vs. 2005 Increase (decrease) Total revenue Net income Average loans and acceptances Average deposits Assets under administration Assets under management $ 2,537 $ 393 18,300 29,700 274,200 47,500 2,248 $ 320 16,900 27,400 198,400 39,500 2,057 162 14,400 25,200 191,800 36,300 $ 289 13% 73 23% 1,400 8% 2,300 8% 75,800 38% 8,000 20% The wealth management and banking businesses in RBC U.S. and International Personal and Business continued to build scale and capabilities through a combination of organic growth initiatives and acquisitions. In 2006, we expanded our distri- bution network and products and services, and focused our expansion in fast-growing markets and regions. RBC Capital Markets (C$ millions, except percentage amounts) 2006 2005 2004 2006 vs. 2005 Increase (decrease) Total revenue (teb) (1) Net income Return on equity (ROE) Average loans and acceptances Average deposits $ 4,693 $ 1,407 29.3% 23,500 118,800 4,062 760 18.1% 17,600 98,900 $ 3,933 $ 827 19.5% 18,600 88,400 631 16% 647 85% 1,120 bps n.m. 5,900 34% 19,900 20% (1) Taxable equivalent basis (teb). By successfully executing growth plans, the businesses in RBC Capital Markets maintained our position as the undisputed leader in the Canadian market, and expanded our activities in the U.S. mid market and our global infrastructure finance platform. Shareholder information Corporate headquarters Street address: Royal Bank of Canada 200 Bay Street Toronto, Ontario, Canada Tel: (416) 974-5151 Fax: (416) 955-7800 Mailing address: P.O. Box 1 Royal Bank Plaza Toronto, Ontario Canada M5J 2J5 website: rbc.com Transfer Agent and Registrar Main Agent Computershare Trust Company of Canada Street address: 1500 University Street Suite 700 Montreal, Quebec Canada H3A 3S8 Tel: (514) 982-7555, or 1-866-586-7635 Fax: (514) 982-7635 website: computershare.com Co-Transfer Agent (U.S.) The Bank of New York 101 Barclay Street New York, New York U.S. 10286 Co-Transfer Agent (United Kingdom) Computershare Services PLC Securities Services – Registrars P.O. Box No. 82, The Pavilions, Bridgwater Road, Bristol BS99 7NH England Stock exchange listings (Symbol: RY) Common shares are listed on: Canada Toronto Stock Exchange (TSX) U.S. New York Stock Exchange (NYSE) Switzerland Swiss Exchange (SWX) All preferred shares are listed on the Toronto Stock Exchange. Valuation Day price For capital gains purposes, the Valuation Day (December 22, 1971) cost base for our common shares is $7.38 per share. This amount has been adjusted to reflect the two-for-one share split of March 1981 and the two-for-one share split of February 1990. The one-for-one share dividend paid in October 2000 and April 2006 did not affect the Valuation Day value for our common shares. Shareholder contact For information about stock transfers, address changes, dividends, lost stock certificates, tax forms, estate transfers, contact: Computershare Trust Company of Canada 100 University Ave., 9th Floor Toronto, Ontario M5J 2Y1 Tel: (514) 982-7555 or 1-866-586-7635 For other shareholder inquiries, contact: Shareholder Services Royal Bank of Canada 123 Front Street West 6th Floor Toronto, Ontario Canada M5J 2M2 Tel: (416) 955-7806 or visit our website at rbc.com/investorrelations 2007 quarterly earnings release dates First quarter Second quarter Third quarter Fourth quarter March 2 May 25 August 24 November 30 Direct deposit service Shareholders in Canada and the U.S. may have their dividends deposited by electronic funds transfer. To arrange for this service, please contact Computershare Trust Company of Canada at their mailing address. Dividend Reinvestment Plan Our Dividend Reinvestment Plan provides our registered common shareholders residing in Canada and the United States with the means to purchase additional common shares through the automatic reinvestment of their cash dividends. For more information on participation in the Dividend Reinvestment Plan, please contact our Plan Agent: Computershare Trust Company of Canada Attn: Dividend Reinvestment Dept. 100 University Avenue, 9th Floor Toronto, Ontario M5J 2Y1 Tel: 1-866-586-7635 (Canada and U.S.) or (514) 982-7555 Fax: (416) 263-9394 or 1-888-453-0330 e-mail: service@computershare.com Institutional investors, brokers and security analysts For financial information inquiries, contact: Investor Relations Royal Bank of Canada 123 Front Street West 6th Floor Toronto, Ontario Canada M5J 2M2 Tel: (416) 955-7803 Fax: (416) 955-7800 Common share repurchases We are engaged in a normal course issuer bid through the facilities of the Toronto Stock Exchange. During the one-year period commencing November 1, 2006, we may repurchase up to 40 million shares in the open market at market prices. We determine the amount and timing of the purchases. A copy of our Notice of Intention to file a normal course issuer bid may be obtained, with- out charge, by contacting the Secretary of the bank at our Toronto mailing address. 2007 Annual Meeting The Annual Meeting of Common Shareholders will be held at 9:00 a.m. (EST) on Friday, March 2, 2007 at the Metro Toronto Convention Centre, North Building, 255 Front Street West, Toronto Ontario, Canada Dividend dates for 2007 Subject to approval by the Board of Directors Common and preferred shares series N, W, AA, AB and AC Record dates Payment dates January 25 April 25 July 26 October 25 February 23 May 24 August 24 November 23 Credit ratings (as at November 29, 2006) Short-term debt Senior long-term debt Moody’s Investors Service Standard & Poor’s Fitch Ratings Dominion Bond Rating Service P-1 A-1+ F1+ R-1(high) Aa2 AA AA AA La Banque Royale publie aussi son Rapport annuel en français. Legal Deposit, fourth quarter, 2006 Bibliothèque nationale du Québec Printed in Canada This annual report is printed on acid-free paper and the entire book is recyclable. Information contained in or otherwise accessible through the websites mentioned in this annual report does not form a part of this annual report. All references in this annual report to websites are inactive textual references and are for your information only. Trademarks used in this report include the LION & GLOBE Symbol, ROYAL BANK OF CANADA, RBC, RBC CANADIAN PERSONAL AND BUSINESS, RBC U.S. AND INTERNATIONAL PERSONAL AND BUSINESS, RBC CAPITAL MARKETS, RBC ASSET MANAGEMENT, RBC CAPITAL TRUST, RBC CENTURA, RBC DAIN RAUSCHER, RBC DIRECT INVESTING, RBC DOMINION SECURITIES, RBC INSURANCE, RBC MORTGAGE, RBC CASH FLOW PORTFOLIOS, RBC HEDGE 250 INDEX, RBC HOMELINE PLAN, RBC MANAGED PORTFOLIOS, RBC NO LIMIT ACCOUNT, RBC REWARDS and RBC TruCS, which are trademarks of Royal Bank of Canada used by Royal Bank of Canada and/or its subsidiaries under license. All other trademarks mentioned in this report, which are not the property of Royal Bank of Canada, are owned by their respective holders. RBC Dexia IS and affiliated Dexia companies are licensed users of the RBC trademark. d n a r b r e t n I Royal Bank of Canada Annual Report 2006 Shareholder information 165 Where our vision leads us R o y a l B a n k o f C a n a d a 2 0 0 6 A n n u a l R e p o r t Royal Bank of Canada 2006 Annual Report Where we are RBC corporate profile Royal Bank of Canada (RY on TSX and NYSE) and its subsidiaries operate under the master brand name of RBC and may be referred to in this text as 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. Our Global Technology and Operations and Global Functions teams enable business growth with expert professional advice and state-of-the-art processes and technology. We employ approximately 70,000 full- and part-time employees who serve more than 14 million personal, business, public sector and institutional clients through offices in North America and 34 countries around the world. In Canada, we have strong market positions in all of our businesses. In personal and business banking, we rank first or second in most retail products. In wealth management, we have the leading (1) full-service brokerage operation, the top mutual fund provider among Canadian banks (1) Based on assets under administration. and the second-largest (1) self-directed broker. We are the largest Canadian bank-owned insurer, one of the top 10 Canadian life insurance producers, and a leader in creditor products, travel insurance and individual disability insurance. In corporate and investment banking, we continue to be the top-ranked securities underwriter and the leading mergers and acquisitions (M&A) advisor. Our domestic delivery network is one of the most extensive of all Canadian financial services companies. In the United States, we provide personal and commercial banking, insurance, full-service brokerage and corporate and investment banking services to approximately two million clients. Outside North America, we have a banking network in the Caribbean and a significant presence in select markets. We offer investment banking, trading, correspondent banking and reinsurance to corporate, institutional, public sector and business clients. We also offer private banking and wealth management services for high net worth individuals and corporate and institutional clients. 1 2 5 6 8 10 12 13 14 17 Financial highlights Chief Executive Officer’s message Performance compared to objectives To be the undisputed leader in financial services in Canada To build on our strengths in banking, wealth management and capital markets in the United States To be a premier provider of selected global financial services Global Technology and Operations and Global Functions Chairman’s message Corporate governance Corporate responsibility 25 Management’s Discussion 99 26 33 38 and Analysis Executive summary Accounting and control matters Consolidated results from continuing operations 43 Quarterly financial information Business segment results from 45 continuing operations Financial condition Risk management Additional risks that may affect future results Additional financial information 63 72 90 92 Consolidated Financial Statements 161 Glossary 163 Directors and executive 100 Management’s responsibility for officers 164 Principal subsidiaries 165 Shareholder information financial reporting 100 Report of Independent Registered Chartered Accountants 101 Management’s report on internal control over financial reporting 101 Report of Independent Registered Chartered Accountants 102 Consolidated Balance Sheets 103 Consolidated Statements of Income 104 Consolidated Statements of Changes in Shareholders’ Equity 105 Consolidated Statements of Cash Flows 106 Notes to the Consolidated Financial Statements This annual report contains 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 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. Additional information about these factors can be found under “Caution regarding forward-looking statements” on page 25. The carbon dioxide emissions associated with the production and distribution of this report have been mitigated by Zerofootprint according to the highest standards in carbon offsetting. Form #81104 (12/2006) This report has been printed on paper stock that contains 10 per cent post-consumer fibre and is FSC (Forest Stewardship Council) certified. FSC fibre used in the manufacture of the paper stock comes from well-managed forests independently certified by SmartWood according to Forest Stewardship Council rules.
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