Q2 2023 KeyCorp Earnings Call
Okay.
Yeah.
[music].
Good morning, and welcome to Keycorp's second quarter 2023 earnings Conference call.
A reminder, this conference is being recorded I would now like to turn the conference over to the Chairman and CEO , Chris Gorman. Please go ahead.
Thank you for joining us for Keycorp's second quarter 2023 earnings Conference call. Joining me on the call today are Clark Khayat, our Chief Financial Officer, and Mark Midkiff, Our Chief risk officer on slide two you'll find our statement on forward looking disclosure and certain financial measures, including non-GAAP measure.
These statements cover our presentation materials and comments as well as the question and answer segment of our call I am now moving to slide three before Clark covers our quarterly earnings results I wanted to discuss our strategic priorities and cover the fundamental strengths of our businesses, which.
Continue to perform well despite the challenging operating environment.
In our consumer bank, we are growing relationship households at an annualized rate of 5% consistent with our Investor day targets.
Our strongest growth continues to be in the west driven by younger clients.
We have also experienced strong growth in wealth management with double digit year over year growth in asset management sales.
In our commercial business, we continue to add and expand relationships through our integrated commercial and investment bank.
Our ability to distribute risk serves us well and importantly serves our clients well through all market conditions.
This quarter, we raised $25 billion of capital for our clients place in 18% of the capital raised on our balance sheet.
This is down significantly from the 30% we placed on our balance sheet last quarter.
Although capital markets remain challenged our pipelines are solid on a year to date basis. Our M&A revenue is up from the first half of 2022, we expect investment banking fees to be up in the second half of the year.
One common theme across our franchises, our longstanding strategic commitment to privacy, having our clients primary operating account, whether it's an individual or a business.
Our focus on privacy as reflected in the quality and diversity of our deposit base.
Nearly 60% of our deposits are from retail small business, well and escrow accounts.
80% of our commercial balances are core operating accounts.
Further 97% of our total commercial deposits are from our relationship clients.
Importantly, these are long standing relationships.
Average our retail clients have been clients of key for over 20 years.
Average our commercial clients for over 15 years.
This quarter, our period end deposits increased by $1 billion. Additionally.
Additionally, we've seen continued growth in the month of July in the appendix of our presentation you can find additional detail regarding the quality and diversity of our deposit base.
We continue to proactively manage through volatility as it relates to the macroeconomic environment, the interest rate cycle and potential regulatory changes impacting our industry.
Going forward he will benefit from a well defined net interest income opportunity over the next 18 months.
As our short term swaps and treasuries reprice, we will see a net interest income benefit that will reach approximately $900 million.
On an annual basis by the first quarter of 2025.
We also continue to be proactive from both a balance sheet optimization and capital allocation perspective.
We are well positioned to build capital and reduce risk weighted assets.
We will continue to prioritize or relationships and exit non relationship business and.
And not in non strategic assets.
In the second quarter, our period end loan balances declined by $1 billion, we will continue to benefit from our strong fee based businesses, which make up over 40% of our revenue.
As capital markets normalize, we will utilize our differentiated platform driving fee income and naturally reducing our balance sheet.
On the capital front, we will benefit as over 44% of our OCI will roll down over the next 18 months the.
The next area I would like to discuss is our exposure to credit in the current environment.
Credit losses remained relatively low across the industry, but as we move through the business cycle asset quality will matter today more than half of our C&I loans are investment grade and over 70% of our consumer originations have a FICO score of 760 or greater these.
These measures reflect the derisking of our portfolio over the past decade in concert with our underwrite to distribute model.
We have limited exposure to leverage lending office loans and other high risk categories.
B and C class office exposure in central business districts totaled a $121 million.
Two thirds of our commercial real estate exposure is in multifamily, including affordable housing, which continues to be a significant unmet need in this country.
We also continue to benefit from insights gained from our third party commercial real estate servicing business as we service over $630 billion of off us real estate exposure.
Finally, we will continue to focus on improving productivity and efficiency. Our results. This quarter reflect the successful completion earlier this year of a company wide effort to improve efficiency.
Actions completed in the first quarter represented over 4% of our expense base and $200 million annualized.
This benefit.
These efforts remain ongoing as we will identify new opportunities to improve both productivity and efficiency.
Before turning the call over to Clarke I wanted to take a step back this quarter, we strategically built capital.
Manage the size of our balance sheet and for the third consecutive quarter built our allowance for credit losses as I covered earlier, we will continue to take steps to manage our level of risk weighted assets in consideration of anticipated regulatory changes I will close by affirming my confidence is.
The long term outlook for our business, we have a durable relationship based business model that will continue to serve our clients our prospects and deliver value to our shareholders with that I'll turn it over to Clarke to provide more details on the results for the quarter Clark.
Chris I am now on slide five for the second quarter net income from continuing operations was 27 per common share down <unk> <unk> from the prior quarter and down 27 from last year driven in part by two notable items a.
Our results included $87 million of additional post tax provision expense in excess of net charge offs or <unk> <unk> per share as we continue to build our reserves.
We also incurred $21 million of notable post tax expenses or <unk> <unk> per share. This includes severance cost refunds on fees and related claims and our visa class B fair value adjustment.
Turning to slide six <unk>.
Average loans for the quarter were $120 7 billion up 11% from the year ago period, and up less than 1% from the prior quarter as we continue to support relationship clients.
Commercial loans increased 12% from the year ago quarter relative to the same period consumer loans increased 7%.
Compared with the first quarter of 2023 commercial loans grew 1%, while consumer loans remained relatively stable.
Total loans ended the period at $119 billion down $1 billion from the prior quarter.
Continuing on to slide seven.
He has long standing commitment to privacy continues to support a stable diverse base of core deposits for funding. Our total cost of deposits was 149 basis points in Q2, and our cumulative deposit beta was 39% since the fed began raising interest rates in March 2022.
We remain focused on balance sheet management with an eye towards minimizing the total cost of funds.
Average deposits totaled $142 9 billion for the second quarter of 2023 down 3% from the year ago period and were relatively stable across the quarter down approximately $500 million on average.
Year over year, we saw declines in retail deposits driven by elevated spend due to inflation normalization from elevated pandemic levels and changing client behavior due to higher rates.
The decrease in average deposit balances from the prior quarter reflects the continuation of the same trends.
Regular seasonal outflows that we saw in April were more than offset in May and June deposits ended the period at $145 1 billion up $1 billion from the prior quarter.
Turning to slide eight.
Taxable equivalent net interest income was $986 million for the second quarter compared with $1 1 billion in the year ago and prior quarters down approximately 11% against both periods.
Our net interest margin was two 1%, 2% for the second quarter compared to $2, 61% for the same period last year and $2, 47% for the prior quarter.
Year over year net interest income and the net interest margin were impacted by higher interest bearing deposit costs a shift in funding mix, the higher cost deposits and growth in wholesale borrowings, which in part supported elevated cash levels.
The decline in net interest income was partially offset by higher yields on loans and investments.
Relative to the first quarter, our net interest margin was negatively impacted by 28 basis points related to higher interest bearing deposit costs at 17 basis points from a change in funding mix and liquidity, partly offset by 10 basis points related to higher earning asset yields and earning asset growth.
Our swap portfolio in short dated treasuries reduced net interest income by $340 million and lowered our net interest margin by 73 basis points this quarter.
Turning to slide nine.
As previously mentioned he has begun to benefit from the maturity of our short dated swap book and expects to begin to benefit more significantly from increasing swap and treasury maturities as we move forward.
Based on the forward curve, we continue to expect a meaningful benefit currently estimated at $900 million annualized in the first quarter of 2025.
We have continued to take a measured but opportunistic approach to lock in this potential benefit in this analysis includes the addition of hedging activity undertaken beginning in <unk> 'twenty two.
We have not and do not plan to replace the swaps rolling off in 2023, instead of allowing the natural asset sensitivity of the loan book to come through and benefit from higher short term rates.
Moving to slide 10.
Noninterest income was $609 million for the second quarter of 2023 compared to $688 million for the year ago period, and $608 million in the first quarter.
The decline in noninterest income from the year ago period reflects a $29 million decline in investment banking and debt placement fees, reflecting reflecting lower advisory and syndication fees. Additionally.
Additionally service charges on deposit accounts declined $27 million, reflecting previously announced and implemented changes in our NSF NSF fee structure and lower account analysis fees related to higher interest rates.
The decline in noninterest income from the first quarter reflects a $25 million decline in investment banking and debt placement driven by lower advisory and syndication fees, partially offset by $10 million increase in corporate services income, reflecting an increase in customer derivative activity.
I'm now on slide 11.
Total noninterest expense for the quarter was 1.0 $7 $6 billion down.
Down $2 million from the year ago period, and down $100 million from last quarter.
Paired with the year ago quarter, net occupancy expense decreased $13 million, reflecting a downsizing of corporate facilities and business services and professional fees decreased $11 million.
These decreases were partially offset by a $17 million increase in technology expense at $15 million increase in personnel expense, reflecting merit increases and higher benefit costs.
Compared to the prior quarter personnel expense decreased $79 million, reflecting lower incentive stock based compensation and severance.
Additionally, other expense decreased $24 million in the second quarter as the first quarter included restructuring charges related to expense actions.
Moving now to slide 12.
For all credit quality remains solid for the second quarter net charge offs were $52 million or 17 basis points of average loans.
So we're really pleased across portfolio does remain relatively stable our provision for credit losses was $167 million for the second quarter, which as we have pointed out exceeded net charge of $115 million or <unk> $87 million after tax.
The excess provision increases our allowance for credit losses to 149% of period end loans.
Quite the increase in the allowance our outlook for net charge offs remains well below our through the cycle targeted level of 40 to 60 basis points.
Now on to slide 13.
We ended the second quarter with a common equity tier one ratio of nine 2% up from the prior quarter and within our targeted range of 90% to 95%. This provides us with sufficient capacity to continue to support our relationship customers and their needs we.
We did not complete any open market share repurchases in the second quarter being on those related to employee compensation, nor do we expect to engage into material share repurchases in the near term.
We will continue to focus our capital and supporting relationship client activity and paying dividends.
On the right side of this slide is the expected reduction in our OCI Mark.
<unk> marked declines by approximately 44% by the end of 2024 and 55% by the end of 2025.
In alignment with recent public remarks from regulators, we expect that any changes will be implemented within appropriate comments and phase in period, given that our view is that for any new requirements, our reduction in <unk> and more significantly our future earnings and balance sheet management.
Allow us to organically accrete capital to the required levels over the necessary period.
Slide 14 provides an outlook for the third and fourth quarter of 2023 three.
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Fourth quarter guidance is given relative to each prior quarter respectively.
Similar to our approach in the third quarter of last year, we have shifted our guidance to focus on our quarterly results. This provides a clearer view of trends heading into year end using the forward curve as of July one.
Balance sheet trends are tracking mostly as anticipated, we expect average loans to be down 1% to 3% in both the third and fourth quarter versus the prior quarter as we continue to actively manage our balance sheet and recycle capital to support relationship clients.
We expect average deposits to be relatively stable in both the third and fourth quarter versus prior periods. Our outlook assumes a cumulative deposit beta approaching 50 by year end.
On a linked quarter basis net interest income is expected to decline, 4% to 6% in the third quarter and be flat to down 2% in the fourth quarter as we derived more benefit from the repricing of our swaps and treasuries and 2024, we expect growth in both our net interest income and net interest margin.
Our guidance assumes the fed funds rate, reaching five 5% in the third quarter remaining flat through year end.
These interest rate assumptions, along with our expectations for customer behavior, and the competitive pricing environment are very fluid and we will continue to impact our outlook prospectively.
Noninterest income is estimated to be up 2% to 4% in the third quarter and up 4% to 6% in the fourth quarter versus prior periods, reflecting a gradual improvement in capital markets.
Non interest expense is expected to remain relatively stable in both the third and fourth quarters.
We assume credit.
Polity remained solid and net charge offs to average loans to be in the range of 20% to 25 basis points in the third quarter and 25% to 35 basis points in the fourth quarter, both below our expected over the cycle targeted range of 40 to 60 basis points.
Our guidance for the third and fourth quarter GAAP tax rate is 18% to 19%.
Using our quarterly guidance, our full year outlook for 2023 versus the prior year would be the following.
Net interest income down 12% to 14%.
Fees down 7% to 9%.
Expenses relatively stable.
Net charge offs of 25 to 30 basis points for the year and our GAAP tax rate of 18% to 19%.
We feel confident in the foundation of our business and our diverse high quality deposit base, the durability of our balanced franchise and our improved risk profile. Despite near term headwinds we continue to be focused on execution in 2023 and positioning the company to benefit from the strong long term core earnings power of our businesses.
With that I will now turn the call back to the operator for instructions for the Q&A portion of our call operator.
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That will come from the line of Scott <unk> with Piper Sandler.
Good morning, guys. Thank you good morning.
Hey Clarke.
Mark wanted to talk about the NII outlook. So the pace of NII degradation. It looks like you should you should slow considerably in the second half of the fourth quarter, especially maybe a little more color on the main factors, you're seeing that would allow that to happen I know you sort of rationalize that the beta expectations and of course, you've got the treasuries and swaps, but just curious to hear.
From your view sort of the main factors in that outlook.
Sure. Thanks, Scott and I think this will be a topic, we're spending a little time on it so.
First let me just remind you that.
The $2 12, NIM would have been $2 85, with this without the swaps and treasuries, which were about $340 million in the quarter.
Just to give you kind of a level set.
If we go back to recent the most recent guidance, we would have guided you to the second quarter being at or near the bottom so to your point, Scott a little bit of.
Continued decline.
What I'd say is the fundamentals of our business are very consistent with that comment what's changed is the right expectation in the back half of the year. So at that time, we were expecting two cuts in the fourth quarter.
As I stated in the prepared remarks, we're now going to see kind of one hike at flat through the end of the year.
And I think the implication of that is the betas will drift a little higher through the back half of the year end.
And the swaps and treasuries will be a little bit bigger drag than we previously expected that said, we do think that both of those factors are moderating. So we're seeing deposit balances stabilize and we're seeing the slope of that beta increase flattened.
And were continued continuing to see swaps mature and the treasury portfolio will begin to mature now in the third quarter. So we'll see opportunity as those as those two books come off.
So what we're seeing that is that flattening of the NII and NIM trajectory as we go into fourth quarter, and we wanted to reflect that by providing guidance for each individual quarter.
As we go beyond that into 2024, I think we will start to see a pickup.
Slide nine isolates the swap and treasury portfolios, so consistent with what we did last quarter.
As I stated a few minutes ago $340 million drag in Q2 or 73 basis points in.
And the way I'd think about it just in its simplest terms is $9 billion of U S. Treasuries that start maturing in this quarter with a basically an average yield think of 45 basis points.
$10 3 billion of swaps between now and the end of 'twenty four with the with our receive fixed rate between 40% and 50 basis points. So put those together you're looking at close to $20 billion with an almost 5% yield pick up by the end of 'twenty four and Thats, what gets you to the $900 million or 200.
<unk> 20 per quarter or 230, sorry per quarter that we have on slide.
Nine in the deck as of Q1 'twenty five.
Again.
In that case, we're trying to isolate just the treasuries and swaps and provide as much transparency as we can there on these specific headwinds what I would say that doesn't include is the relative betas or funding costs that go with that but I just wanted to touch on that because again I think it's important to understand.
If you look at.
The $720 million, which is equivalent to the 900 that we quote this quarter that was consistent with our.
A different rate environment, where rates were coming down at the end of the quarter or the end of the year and we would have had a.
Muted slightly muted impact on the NII pickup.
As I, just said rates, we think are going to be higher now the betas will be higher but commensurately the pickup in those swaps and treasuries has gone from $740 to 900. So those are going to move in sync slide nine is intended to be again isolated to the treasuries and swaps just to make sure. We're giving you as much disclosure on those as we can.
Okay.
Really helpful color I appreciate that and I don't want it but the words in your mouth, but in the aggregate would your expectation be that NII ends up sort of sort of bottoming around end of this year. Maybe early next year, but then does see a more visible inflection back up as sort of the.
The pricing dynamics weighing on funding costs, but.
You then start to get a more material and physical benefit from the swap and treasury maturities is that that's the way to think about it yes, I think that was very well stated.
Okay, Alright, perfect. Thank you very much I appreciate it thanks.
Thanks Scott.
We will go next to the line of Abraham Cornwall up with Bank of America.
Hey, good morning, Hey, good morning, Ebrahim I guess.
Good morning, guys just wanted to follow up I think.
On the same line of questioning that Scott around NII. So.
I appreciate the update.
If some swaps and casualties.
The concern when you talk to investors has been.
The valley before we get to that point kept getting deeper tool dealer. When we look at this guidance for the back half I think Clark you mentioned implies negative 12% year over year.
Give us a sense of just a level of confidence in that guidance.
Is it absent any big change in the interest rate backdrop, how good do you feel and the level of visibility that you have and I. Appreciate it's been tough for the entire industrial handicap. This but any color you can provide would be helpful.
Sure.
So look I think the biggest changes we've gone through the year has been the rate.
The rate level so.
Given your commentary on sort of relatively stable rates I think we feel very good about that.
Trajectory, we're sharing here.
And I would say overall, our deposit beta is I feel like are very much in line with the peer group. We did some catching up because we outperformed last year, but I feel like that's very consistent with what's happening in the industry and we just happen to have these specific headwinds right now on swaps and treasuries, but again as those come off.
We think we're prepared to get the benefit of that so I would say that.
In the expected rate environment, our confidence would be good.
Got it and second question I think Chris talked about two things one is focus on expenses.
I see the guidance for flat expenses for the back half.
Give us a sense if there is a bigger opportunity yet on.
<unk> expense leverage as you move into back half and is it can you just read thinks about 2024, EPS and also around any proactive RWD actions I think you mentioned getting laid off.
Existing non strategic relationships, how impactful could that be for cash and capital.
Sure. So that's a great question and as you.
Put them together they are closely related so if you just step back here's here's how we see the future as.
As all of the rigs.
<unk>.
What's not going to change for us Abraham as we're going to remain focused on our relationship model, we're going to stay focused on targeted scale, but I think theres going to be incredible and intense scrutiny around duration.
Daniel clarity of the composition of the deposit base and that's one of the reasons that Clarke talked about that we pivoted and made sure we protected our deposits, whereas we were kind of leading in terms of.
Not having a lot of beta next gets too I think there is and this gets directly to your question I think there's going to be a significant change in loan to deposit ratios as you kind of run all of this through your models and we run it through our models.
Zinc loan to deposit ratios for category for banks, if they're mid <unk> now, they're going to be significantly less and we are very focused on this and so keep in mind last year. We grew our loans kind of high double digits, I mean around 19% I should say.
High teens, and then we were on a path to grow 6% to 9%, but that all happened in the first quarter before the events of March and we not only stop that growth, but actually pushed it back a $1 billion by the end of this quarter, which I think I think is really really important and right now what we're doing is we.
We are scrutinizing every portfolio, we have in the bank I've always said that on a risk adjusted basis. Most loans. Most standalone loans don't return their cost of capital and if you think about having to carry more capital and you think about the capital that you have being a lot more expensive than you can.
Rest assured there'll be a lot of credit only.
<unk>.
Relationships that won't be strategic to us. So we will preserve our capital for those relationships. As you know we can do a lot with them, but we will be continuing to push down.
Our assets.
You see in the guidance that Clark gave you.
Looking at average loans being down 1% to 3% in the third quarter and down 1% to 3% in the fourth quarter, we will hit that.
So and then the second part of your question, which is also related as we shrink the balance sheet, we're going to have to make sure that our expense base is right sized for the future asset base of our company and rest assured we're looking at that as well.
And then just if I can.
Squeeze one in.
Just give us a sense of the dividend there's been a lot of focus the 7% dividend yield.
And the chairman of the board I know its evaluated every quarter, but how confident are you in terms of dividend sustainability.
Kind of plot through the back half into 'twenty for sure.
Sure.
The headliner there as I am confident but as.
As a board member we spend a lot of time talking about strategy and talking about dividend policy. We manage this company for the long term.
And the dividend policy is no exception our capital priorities as I just mentioned are unchanged. It is to support our clients our prospects and to pay dividends and to your point last week. Our board did approve a 25 cent third quarter dividend keep in mind over our history, we have paid out 80%.
Very very often it's just been in the form of both buybacks and cash dividend.
So we're.
Obviously paying close attention to that I feel good about it.
Let me talk a little bit about capital because it's so related.
This in spite of some of the challenges Clark mentioned this quarter. We grew capital we paid a 25 cent dividend and we built reserves and so as we think about taking this long term perspective.
When you look at our normal normalized earnings power of our company and that is the reversal of the NII headwind into a tailwind and also having a reasonable expectation around investment banking fees.
The earnings power of the company is strong we can build capital there.
Clark mentioned, the OCI burned down 44% by 12, $31 24, 55% by 12 31 25.
And then.
As I just mentioned this game plan that we have around risk weighted assets will be important and then the last thing that I think is really important.
And it's going to be important I think as the cycle continues to play out.
We have a well positioned credit book and there is nothing that destroys capital faster and in bigger and bigger hunks than having a bunch of credit losses. So I put all those things together, we take a long term perspective on the dividend we feel good about it.
All very helpful color. Thank you so much.
Sure. Thank you rebrand.
We will go next to the line of Ken Houston with Jefferies.
Hey, guys.
Just a couple of follow ups on the on the loan side.
Obviously, you said that you are.
You're retaining a little bit back to kind of that upper teens point.
Of your invested in investment banking originations and I'm just wondering.
Yes.
Does that have any storm put in terms of the ability to generate business in the investment bank and I guess connected just then your confidence in the second half improvement in the investment bank is that because you start you're starting to see things get back out the door as opposed to.
Keep on the balance sheet like you had been doing for the last couple of years.
So first of all thank you for your question Ken.
It's complicated by the fact that as usual mix has a lot to do with it. So we actually distributed a lot of that in the second quarter. The reality is a lot of it was investment grade. So in terms of investment banking fees not so great in terms of keeping the velocity of our balance sheet very very important but the premise of your <unk>.
<unk> as we look to shrink.
Our balance sheet, the ability to distribute paper to a lot of different places.
We will be.
We will in fact be important and so that'll be an important part of the mix in terms of what I'm seeing.
Kind of what I'm seeing one our M&A backlog year over year is up our total backlog is down but down kind of mid single digits, which is really.
Not a big deal what I'm. Most encouraged by is not that I'm seeing things coming out of the pipeline obviously in the equity market. We're starting to see that you are seeing that for sure.
But what I'm really pleased with as I talked to our clients. All the time in fact as recently as yesterday I talked to one of our large clients who is proceeding with a transaction that's been sort of percolating for some time as people kind of go through the price discovery. So.
It's really more a gut feel on my part having been around this business for so long.
Got it and just one more.
Laurel Road some.
Some cross factors there to obviously with the debt moratorium and what happens there, but just as far as also being scrutinizing every incremental loan that you were making just can you talk about the.
Laurel Road, specifically, but how youre also thinking through that in terms of the other consumer portfolios.
Sure I'll start and then I'm going to flip it over to Clarke, but it's a great question and its one as we sort of have gone through our reset. We've spent a lot of time talking about these capabilities that we need to make sure. We had before we bought Laurel road, they securitized and distributed a 100% of their loans.
Going forward, we're going to be securitizing and distributing their loans. We have we have the people and we have the ability to do it.
So it's a really good question, while I'm on the point of lower road. The other thing we've done on Laurel Road. So we've really made it really made two pivots and what's been going on with the federal student loan payment holiday. One we turned it into a complete digital platform whereby we can have.
Loans deposits importantly, checking account card mortgage et cetera.
Other thing that we did is when we bought <unk> and we're in the early days of this Ken but Grad fin is a market leader in advising people around not only public service loan forgiveness, but the whole income based debt repayment, which the government is really opening up the aperture for.
It's falsely complex and you need someone to sort of help you through it which is a good thing, but thats. Another pivot that we've made there but getting back to your question about sort of our asset light model Clark why don't you talk about.
Speak to that particularly Rob mortgage as well.
So I think.
Largely we're going to look to continue to distribute I mean, we do have capabilities now when we distribute a lot of that we're going to expand that more consistently I think to the consumer side. The point I think a lower road that Chris made that I just want to reiterate is we never acquired it to be a student loan only generator that was kind of the headline it was intended to be.
A full service banking platform, we continue to build towards that and we think it's got some really unique and differentiated capability around this.
Driven repayment.
Public service loan forgiveness, and you may have seen some.
Some commentary out of the government in the past week around <unk>, specifically in some of the complexities of that which I think will accrue to our benefit over time.
Got it so if I can wrap that together is it fair to say that the tradeoff of less NII.
Less loan growth over time, getting the LDR down Youll sacrifice some NII help on the capital side, and then move towards more of a fee generating model.
Yes, yes.
Yes, I think thats the right idea I think we're also demonstrating more deposit growing capability, there and again, we're still relatively new and having those capabilities but.
I think thats the right way to think about it so more of a fee.
<unk> and core banking generator than a loan.
Our loan shop.
Okay got it thank you.
Yes.
We'll go next to the line of John <unk> with Evercore. Please go ahead.
Good morning, good morning.
Okay.
Just going back to the 900 million on slide nine of NII pickup from Treasury and swap maturities.
So let me just ask it this way aside from <unk>.
The change in the rate backdrop in your interest rate outlook.
What could prevent you from realizing that.
I know, there's a fair amount of investor skepticism around the ability of that 900 million to find its way into the numbers.
Your perspective, how do you size up the risks what are the risks.
You do not realize that what gets in the way is it more on the deposit side or is it an asset side.
The picture that could prevent that from being realized.
Yes.
I think I mean the rate of <unk>.
<unk> when the when the treasuries and swaps mature is sort of the single biggest factor in that would be it would have been reflected in.
The 720 move into 900 so.
And again Thats isolating kind of the income portion of that I do think.
There's a couple of variables, so think about the treasuries, whether or not we reinvest them in the market use them as replacement funding or hold them in cash today. Those are relatively neutral over time. If there is a disparity between those three you might see a little bit of pickup.
Or drop depending on which decision we make but today, it's kind of a push across all three of those.
And then your other point was right, which is the funding side of this so I tried to reflect that as well in my comments.
Lower beta expectations at the end of Q1, when we showed you a 7% and 20 opportunity higher beta expectations here today, but that opportunity is gone up kind of interrelated way. So I don't know and I don't want to pretend those are kind of one to one type, but I would think about those moving at least in a fairly correlated direction.
Got it Okay, alright, thank you and then.
Separately.
As you continue to exit.
As you are evaluating.
The non strategic businesses and other optimization.
Just to confirm any progress you make incrementally on that front that would be an addition.
The guidance.
Klein of 1% to 3% on the loan front.
So anything on the incremental optimization that would provide that would lead to potential incremental downside to those numbers.
I think if there were something.
More significant than what Chris referred to which is maybe a very active management of the business that would be incremental but I think what we built into this guidance is how we're running the business right.
Okay alright, thank you.
We'll go next to the line of Matt O'connor with Deutsche Bank.
Alright, good morning wanted to follow up on the kind of capital line of questions. I guess, the first thing is a lot of your peers seem to be targeting 10% plus on the Q1 and obviously there is.
Capital proposals coming out, but I guess first question was wondering your thoughts in terms of that 99, 5% target moving closer to tend to tend to have like some of your peers.
So Matt.
We think nine to nine 5% is the right number for us given our business mix. If you think about 50% of our C&I book being investment grade. If you think about the fact that we don't have really any credit card business to speak of if you think about the fact that funding.
We have FICO scores in our consumer business of 760, or so we think it's we think it's the right number and obviously at $9 two and having grown it from $9. One this quarter, we're right in the strike zone having.
Having said all of that.
We like everybody else, we'll wait and digest anything.
Anything that comes out.
In the not too distant future.
Reevaluated.
At that point, but for our business right now we feel that's the right number.
Okay, and then in terms of the <unk> optimization is it possible to size that or give a range and the timing of when you'll get the benefit of that.
We're looking at a lot of different things right now Im most comfortable just directing you to the guidance that we gave around loans, but as I've mentioned.
We're looking at other things as well I'll leave it at that.
Okay. Thank you.
Thank you Matt.
Well go next to the line of Manav Gagliano with Morgan Stanley .
Hi, good morning.
I wanted to clarify your comments earlier on the call that you believe that the LDR is for the industry and category for banks in particular will have to.
Move lower.
Does that mean that you have some room to optimize some of your non deposit funding like longer term debt.
Or is that unlikely given the potential for T laterals to also apply for category for banks.
Yes, so I think that we do have that and you would have seen us do a little bit of that even here in the second quarter. So.
I think your follow on question around T. Lack of long term debt is the right one as well and we'll wait as Chris just mentioned for the.
The proposed and final rules, but we do think that.
Reduction in loan to deposit over time gives us it gives us an opportunity to reduce reliance on wholesale funding.
Got it Okay, and then maybe on the credit side.
Given the ACR was up this quarter.
Well.
Was that.
Early model driven.
<unk>.
I guess, how much of a buildup.
Is that more of a build out to do and.
What sort of an environment do you have baked into that current reserve ratio.
Sure. So just from a seasonal perspective, obviously, it's very forward looking in terms of what percentage is model driven what percent is kind of a portfolio driven I think you can assume it's kind of sort of half and half.
And my assumption is that.
Just to step back for a second my assumption is that we will have I think the fed is going to successfully engineer a soft landing I think it will probably happen in 2024, having said that what I don't think as yet in the market is the impact of all the rate increases and also.
The impact.
Thanks.
Turning down on credit and I think both of those will have an impact on the economy and as such we're pretty conservative in terms of how we look at things and so the first thing we always do is look at anything that.
As is leveraged and anything.
Where the cash flows could be in any way impacted by a slowing economy. So that's kind of the lens that we've looked at it. There is nothing specific there is nothing that we're particularly worried about we kind of look across all the portfolios.
So as we.
If we do move to a soft landing would that imply that you don't need it.
Our ratio is to really move higher.
Yes, right now I feel like we have reserve, what we need to reserve for sure.
Got it thank you.
Thank you we'll go next to the line of Mike Mayo with Wells Fargo Securities.
Hi can you hear me.
Yes, Mike we can good morning.
Good morning.
So youre guiding NII down 4% to 6% in the third quarter and another zero to 2% in the fourth quarter.
What does that mean for your NIM, even in broad terms. It was I guess it was $2 one 2% in the second quarter.
Yes, we would expect it to be relatively flat in the third quarter, and then start to trend up.
Okay. So my question is look that's the lowest core margin possibly ever.
Yes at least since the global financial crisis, I mean and as such.
Slim margin here and then.
So I guess.
Why such a low margin and even after the increase.
I guess I get to around.
NII of about 1.15 billion per quarter, which is where you were in the second quarter of 2022.
Just before the fed rate hikes, and you can correct Matt.
Using the midpoint here NII at 986.
Goes down to 937 next quarter and the $927 million in the fourth quarter and then I guess you are saying it goes up by about one fourth from there by the end of the year right.
So 997, plus one fourth of that $900 million annualized gets you around $11 50.
NII, so I'm, sorry, a lot of numbers around here, but in the end you wind up with a NIM you wind up with NII thats at a level before the fed rate hikes, so even with the potential improvement next year, which would be an incremental positive.
You are still not getting.
Getting credit for any of the fed rate hikes and it took place so what happened with the structural positioning of the balance sheet that leads to such a low NIM and NII.
So I mean, what.
Where I would start there Mike is that if you look at the composition of our loan book in General It is in our view higher credit quality, but higher credit quality comes generally with lower.
Yields so we have.
Over 50% of our C&I book is investment grade, we have Super Prime consumer books. So those are not going to carry the same rates broadly as something like credit card, which we have very little exposure to a personal consumer loans, which we have very little exposure to so.
And that in that regard.
We're starting probably structurally from a little bit lower NII, but the counter to that is what we think is a higher credit quality book So.
I'll have to go back through the specific math you have there but.
I'm happy to do that and talk about it offline but.
I think that's at least a starting point, but we think over time.
NIM.
It starts with the three is not.
Not an unreasonable place for us to be.
And so is that right. So next year, you're guiding basically from the fourth quarter level, where it stabilizes at least the NII should go up by about one fourth by the end of the year and others Youre guiding basically close to 900 million for the fourth quarter or a little above and then youre, saying youre gaining.
$900 million annualized by the end of next year, so that would imply.
NII would go one fourth higher from that fourth quarter level, all else equal is that correct the logic.
Not exactly so the $900 million is annualized as of the first quarter of 2025.
Okay. So just a little bit later got it.
Eventually yes.
For us.
And I said the words all else equal.
What would not be equal what could help NII.
NII and what could help that NIM go back from 2% to 3% what does that logic missing.
Well I think it's.
The obvious one right. There is the 73 basis points that comes from swaps and treasuries. So that's what we're talking about.
And.
Beta is I think getting or general rates and betas getting kind of more in line with historical averages or overall funding costs. So as we just talked about we have some opportunity to reduce some wholesale funding, which is obviously expensive.
And we've still yet to see pull through on loan spreads so.
I think theres a variety of factors that could improve that many.
Many of which we are either not experience at the moment or havent seen.
Kind of broadly in the industry.
And then last one Chris you started off saying you expect investment banking to be stronger in the second half of the year. It's.
It's been some drought for the industry.
Gives you confidence either for the industry.
Four key or for both.
Mike.
Was just meant.
<unk> mentioned this earlier in the conversation it is based on my experience being around this business as long as I have people will deferred transactions for so long, but essentially sort of a log jam starts to break I think we're starting to see it a little bit in the <unk> new issue equity business.
And I've just been out talking to clients and I think people that have put deals on hold now for 12 months either these deals are going to start to happen or theyre going to move on and do something else. So it's based on one just looking and scrutinizing the backlog and then secondly, just more instinctive.
Talking to people.
So Fisher Cup date time, yes for sure.
Okay. Thank you.
Thank you Mike.
We'll go next to the line of Erika Najarian with UBS.
Hi.
Question from.
Hey.
Was your adjusted CET line in the quarter.
Including LCI and I presume that line item.
T one target would be fully.
Fully loaded target even after we get an NPR that would be inclusive of Mci and <unk> line.
So whatever that.
Whatever that ultimate target is Erica will reflect the appropriate rules so.
The Aoc opt out is is eliminated then yes, I think you stated that correctly so.
<unk>.
<unk> hundred 30 that level four.
<unk> is about 630.
Got it.
So my second question is for you Chris.
I apologize if this sounds challenging but this is sort of the big conversation that I'm, having with long term shareholders clearly.
The stock price performance today is trying to price out some of the.
Dividends here is that we're in the market given where your yield is.
And I think the big discussion I'm, having with your investors is that 80% payout right that you meant that you mentioned.
Yes that happened for this quarter it feels like three years ago.
Pandemic yours.
Getting the same question about the sustainability of your dividend and it feels like at the at the end of the day, it's really the denominator that has been challenged so whether it's been expenses previously or.
Having the balance sheet set up to have these received fixed rate debt essentially implied zero rate environment forever.
It just feels like your efficiency ratio and then just quite right and doesn't really reflect the potential of the business. So as you think about.
The next three years how.
How are you what discretionary you're going to have with your board you have that.
Earning potential of your franchise really be reflected in your earnings power I mean, the NIM is the name and I get the swaps lately.
Yes.
At that time, the key gets wrapped up in the dividend conversation that entire time not necessarily because the dividend is an albatross and it feels like that.
Your earnings power is.
<unk> bakeries of the math.
Okay.
Well first of all I appreciate the question.
Agree with the premise of it our business that the challenging thing for us and we just I was with my board.
Last week, and we were talking at length about this our challenges our business is performing well.
We clearly are under earning and were under earning based on how we have our balance sheet position and that's why I mentioned one of the things that gives me confidence Erica is when we get the normalized earnings power of the company. We just talked about investment banking fees thats, driven by something else, but what we really need is the <unk>.
<unk> that we have which is liability sensitive at a time when you wouldn't want to be liability sensitive we need for that to burn off ad.
The passage of time, we will do a lot on that unfortunately.
It is the passage of time, but as I mentioned that burned down is 44% between now and 12 $31 24, and 55%. This is as it relates to OCI by 12 31 25. So that is the issue and I think we or said differently. We are under earning right now and we will.
Be over earning as the position on wines and rolls down.
Got it okay. Thank you.
Thank you.
And we will go next to the line of Gerard Cassidy with RBC.
Thanks, Chris Clark.
<unk>.
Chris you touched on in your opening remarks about this.
Commercial mortgage servicing portfolio I think it's been $630 billion can.
Can you share with us the special servicing segment within that business, obviously with the challenges in the commercial real estate market, particularly in the <unk> market I suspect your special servicing business is picked up and maybe some color there.
Sure well thanks for the question.
It's a great business, it's a great business because it generates a bunch of deposits through S grows which are more important today than they ever have been in my career. It's also important because it is countercyclical so.
For those of you that aren't as familiar with the business.
We are the named special servicer.
In a large complex debt financing is put together and so when you are the named special Servicer, you get sort of what I would think of as sort of a ticking fee and then if in fact it goes into default and this is all office real estate, we are the workout agent and to Gerard points.
We just set for the second quarter in a row a record in terms of special servicing fees.
So I.
I think that will continue this won't surprise you Gerard but.
More than two thirds of what is in active special servicing is office.
And.
I think that's going to continue.
<unk> office is going to be it's not going to be a challenge for key because it is not an asset class. We focus on what I think office is going to continue to be a significant challenge.
And Chris based on your experience with this these fees.
They with you for a while.
Since the work I would say is quite a bit of time.
Yes.
These are these are very large I think it's kind of very large advisory fees that take a lot of people. These are very complex capital structures. It's not unusual for these fees on a single deal too.
The 567 million.
Great and then sticking with this.
Can you share with us just on commercial loans commercial real estate necessarily just what you guys are doing to get out in front of any potential challenges we could see if the economy. I know you said, it's soft landing is what you were thinking but if the economy does lead to more delinquencies and defaults what are you guys doing.
Now to get in front of that.
This is an area, where we spend a lot of time.
As it relates to the C&I book, particularly focused on anything that has floating rate debt that's leverage.
For us our leverage book literally as is the same that it was a decade ago, it's under 2% of our loans and it's focused on our industry verticals, but theres a lot of us Mark mix shifts in the room with me is our chief risk officer, P&I and others are laying eyes on this.
We feel really good about where the portfolio is but.
Anytime you go into an environment, where you have declining EBITDA.
Our business with a lot of leverage as the cost of capital going up you've got to pay close attention and that's where we pay very close attention. We feel good about we feel really good about all of our portfolios, but thats, where I spend my time, because thats whats most vulnerable.
Thank you.
Thank you Gerard.
And we will go next to Steven Alexopoulos with J P. Morgan.
Hi, good morning, everyone.
Steve Alexopoulos.
I wanted to first.
Follow up on your answer Chris to Ebrahim. <unk> question are you signaling that the door is not open at all in terms of potentially right sizing the dividend.
I wouldn't say, it's not opened at all the reason I would put that caveat as I've yet to see the new capital rules.
But what I'm, saying is I'm very comfortable with our dividend payout.
And the trajectory of our business under the current construct.
Got it okay.
That's helpful and then on the fee income guide I heard the messaging around green shoots of capital markets, but those really needed to get us to this range right. The 4% to six and then sorry up two to four and then for detection or are there other factors, which give us some cushion if the ibp's don't come back.
So you could still deliver on the fee income guide.
There's other areas, where we have cushion, but investment banking fees are a big component of that.
We need to have more trajectory in the back half of the year on investment banking fees that we did in the front half of the year in order to hit these numbers.
Got it okay.
And then finally, just big picture view, obviously, a lot of questions on the NIM.
Just as surprises might exceed $2 12.
For Clarke, how do you think about managing the balance sheet and interest rate risks differently. So you don't get in this situation again, where the NIM is this low dividend payout ratios as high you're missing on the NII guidance, which is really all tied to what we're seeing on the swaps, but how do you think about big picture. So once you do get into a 3%.
NIM range that you've sort of hanging around there. Thanks.
It's a great question.
Think and it probably requires a longer answer but short story, Steve I think you just have to be.
Probably considering a variety of additional scenarios and being a little bit more dynamic in the.
The direction and pace.
Movement so.
I think if rates had moved in an orderly fashion.
This would be much less of an issue that they did not as you know and I think we just have to be more dynamic in our thinking about putting on certain positions.
Got it okay. Thanks for taking my questions.
Thank you and there are no further questions in queue at this time I'll turn it back to Mr. Currently.
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