James C. Leonard
Executive Vice President and Chief Financial Officer at Fifth Third Bancorp
Thank you, Tim, and thank all of you for joining us today.
Our second quarter results were once again strong despite the market headwinds. We achieved an adjusted efficiency ratio of just below 55%, which is a 4-point improvement compared to the prior quarter. Our second quarter adjusted PPNR grew more than 8% compared to both the prior quarter and year ago quarter, driven by the continued diversification and growth of our fee revenue streams combined with disciplined expense management throughout the bank.
Net interest income of approximately $1.46 billion increased 9% year-over-year, but did decline 4% sequentially. Our sequential NII performance was the result of our deliberate actions to grow on balance sheet liquidity to support a defensive balance sheet position, given the uncertain macroeconomic outlook and tightening liquidity conditions. Interest-bearing deposit costs increased 54 basis points to 2.3%, which represents a cycle-to-date beta of 45% on interest-bearing deposits, which includes the impact of CDs.
Adjusted non-interest income increased 2% compared to the year ago quarter, with increases in mortgage fee income and commercial banking revenue, partially offset by a decline in deposit service charges due to the impact of earnings credits from higher market rates and the elimination of our consumer NSF fees in July of last year. Adjusted non-interest expense increased 10% compared to the year ago quarter as elevated compensation and benefits expense was driven by non-qualified deferred compensation costs, the minimum wage increase that went into effect in July of 2022 and continued investment in dividend finance. Additionally, expenses increased from higher technology and communications expense and the impact of the increased FDIC assessment that began in January. Excluding the impacts of non-qualified deferred compensation, which are offset by a gross up in securities gains, the FDIC assessment increase and incremental expense growth from dividend finance, total underlying expenses increased approximately 4% compared to the year ago quarter.
Moving to the balance sheet. Total average portfolio loans and leases were stable sequentially in both commercial and consumer portfolios due to our continued discipline with respect to client selection and optimizing returns and also reflecting softening demand. The period-end commercial revolver utilization rate of 35% decreased 2% compared to last quarter. C&I balances were flat compared to the prior quarter as strong middle market loan production and muted payoffs were offset by the lower revolver utilization. Corporate banking production was also tempered due to our focus on optimizing returns on capital in this environment and lower customer demand.
Average total consumer portfolio loan and lease balances reflected growth from dividend finance, offset by declines in indirect auto and residential mortgage. Average total deposits were flat compared to the prior quarter as increases in CDs and interest checking balances were offset by a decline in demand deposits. By segment, consumer deposits increased 1% and commercial deposits decreased 1%, while wealth and asset management deposits declined 12%, reflecting the impact of tax payments as well as clients' alternative investment options.
June activity reflected continued momentum such that period-end total deposits were up 1% compared to the prior quarter. Notably, we have grown deposits 2% since the end of last June compared to a 5% decline for the top 25 banks as shown in the Fed's H8 data.
Moving to credit. As Tim mentioned, credit trends were stable with our key credit metrics remaining below normalized levels. The net charge-off ratio of 29 basis points increased 3 basis points compared to the prior quarter. The NPA ratio of 54 basis points was up 3 basis points compared to the prior quarter. In consumer, we have focused on lending to homeowners, which represents 85% of our consumer portfolio. We have also maintained one of the lowest overall portfolio concentrations in non-prime consumer borrowers among our peers. In commercial, we have maintained the lowest overall CRE concentration as a percent of total loans relative to peers for many years. Within CRE, we have limited office exposure with a low and improving criticized asset ratio and almost no delinquencies.
We continue to watch office closely and believe the overall impact on Fifth Third will be limited. We had deemphasized office even before the pandemic, and we are not currently pursuing new office CRE originations. From an overall credit management perspective, we have continually improved the granularity and diversification of our loan portfolios through a focus on generating and maintaining high-quality relationships.
As many of you know, we have been and remain cautious in our economic outlook. We tightened underwriting standards during COVID, including stressing credits to an up 200 basis point scenario off the forward curve, which limited our growth but improved the stability of our balance sheet. Since we began tightening underwriting standards, roughly 90% of our commercial portfolio has been re-underwritten.
Our criticized assets have been stable over the past several quarters. Across all loan categories, we continue to closely monitor exposures where inflation and higher rates may cause stress.
Moving to the ACL. Our reserves increased $87 million, reflecting the impacts of dividend finance and Moody's macroeconomic forecast, which eroded slightly. The ACL ratio increased 9 basis points sequentially. As you know, we incorporate Moody's macroeconomic scenarios when evaluating our allowance. The base economic scenario from Moody's assumes the unemployment rate reaches 4.3%, while the downside scenario incorporates a peak unemployment rate of 7.8%. We maintained our scenario weightings of 80% to the base and 10% to each of the upside and downside scenarios.
Moving to capital. Our CET1 ratio increased 25 basis points sequentially, ending the quarter at over 9.5%. Our capital position reflects our ability to build capital quickly through our strong earnings generation. Our tangible book value per share, excluding AOCI, increased 11% compared to the year ago quarter. We continue to expect a meaningful improvement in our unrealized loss position assuming the forward curve plays out, resulting in approximately 36% of our current loss position accreting back into equity by the end of 2024 and approximately 50% by the end of 2025.
Looking forward, we expect to build capital at an accelerated pace given our RWA optimization initiatives and by extending our share buyback pause. As Tim mentioned, we will postpone repurchases until we have more clarity on the regulatory environment in order to determine the new level of required capital dollars. Assuming we do not buy back shares through the year-end, we would anticipate accreting capital such that our CET1 ratio ends this year at or above 10%.
Moving to our current outlook. We expect full year average total loan growth between 1% and 2%, which reflects our cautious outlook on the economic environment and our decision to proactively adapt our balance sheet to the new regulatory regime. We expect total commercial loans to increase in the low-single-digits area compared to 2022, which implies a decline in the second half of the year relative to the first half. This outlook assumes the revolver utilization rate of 35% in the second quarter remained stable throughout the remainder of 2023.
Our commercial loan outlook also assumes that we meaningfully reduced originations in certain areas of the commercial franchise, predominantly in the corporate bank to meet our higher risk-adjusted return thresholds, while continuing to increase originations in our core middle market business. We expect total consumer loans to be stable to down slightly from reduced originations of the lower-yielding out-of-footprint auto and specialty lending channels, combined with portfolio residential mortgages, partially offset by growth from dividend finance. We currently expect to originate approximately $4 billion in dividend loans for this year, which is a modest decrease from our previous expectations.
We continue to expect to grow deposits in the back half of 2023, assuming stable or even slightly tighter market liquidity conditions consistent with our track record over the past year of taking market share and maintaining high levels of core operating relationships in both consumer and commercial. Within that, we continue to expect migration from DDA into interest-bearing products throughout the remainder of 2023 with the mix of demand deposits to total core deposits declining from 30% in the second quarter to 27% by year-end, as we discussed last month.
For the third quarter of 2023, we expect average total loan balances to decline 1% to 2% sequentially, with commercial down in the low-single-digits area and consumer stable to slightly down. We expect average deposits to be up 1% on a sequential basis, impacted by our strong finish to the second quarter, some seasonal uplift and the benefits of our multiyear investments in the franchise that Tim discussed earlier.
Shifting to the income statement. We estimate full year NII will increase 3% to 5%, consistent with our comments from the mid-June investor conference. Our NII guidance assumes a cumulative beta of 53% by the fourth quarter, assuming an additional 25 basis point rate hike in July and no further rate movements in 2023. Our outlook translates to total interest-bearing deposit costs increasing around 40 basis points in the third quarter and another 15 basis points or so in the fourth quarter. Our guidance assumes that our securities portfolio balances remained relatively stable between now and year-end.
As a byproduct of our strong deposit growth, combined with lower loan growth and stable securities balances, we expect to hold closer to $15 billion in cash and cash equivalents by year-end. We expect our loan-to-core deposit ratio to end the year in the mid-70s area, which will keep Fifth Third in a strong liquidity position in anticipation of more stringent regulatory environments. We expect third quarter NII to be down approximately 2% to 3% sequentially due to the continued impacts of the balance sheet dynamics I mentioned.
We expect adjusted non-interest income to be stable in 2023, resulting from continued success, increasing market share due to our investments in talent and capabilities with stronger gross treasury management, capital markets, wealth and asset management and mortgage servicing revenue to be offset by higher earnings credit rates on treasury management, subdued leasing remarketing revenue and a reduction in other fees due to lower TRA and private equity income this year. We expect our fourth quarter TRA revenue to decline from $46 million in 2022 to $22 million in 2023. We expect third quarter adjusted non-interest income to be down 3% to 4% compared to the second quarter.
We expect to continue generating strong revenue across most fee captions, which we conservatively assume will be more than offset by a slight erosion in debt capital markets and mortgage revenue, reflecting the environmental headwinds as well as lower other non-interest income.
We continue to expect full year adjusted non-interest expenses to be up 4% to 5% compared to 2022. If capital markets fees improve relative to our current expectations, we will likely land at the upper end of the range.
Our expense outlook incorporates the FDIC insurance assessment rate change that went into effect on January 1, the mark-to-market impact on non-qualified deferred compensation plans, which was a reductant in 2022 expenses but an increase in 2023, and the full year impact of investments to grow the dividend finance and provide businesses. Excluding the FDIC assessment and NQDC impacts, we would expect our full year 2023 core expenses to be up 3%.
Our guidance reflects continued investment in our digital transformation, which should result in technology expense growth in the low-double-digits for the year. We also expect marketing expenses to increase in the mid-to-high single digits area. Our guidance also factors in the run rate benefits from the severance expense recognized in the first half of the year, which reflected proactive actions taken to reduce ongoing expenses given the operating environment.
We expect third quarter adjusted non-interest expenses to decrease 1% to 2% compared to the second quarter.
In total, our guide implies full year adjusted revenue growth of 3% to 4%. This would result in an efficiency ratio of around 56% for the full year. We expect full year total net charge-offs to continue to be in our previously stated 25 to 35 basis point range. However, as you would expect, with normalizing credit costs in this environment from record low levels, there may be a little lumpiness in C&I in the second half, such that total Bancorp's third quarter losses are expected to be 35 to 45 basis points and then fourth quarter losses improving relative to the third quarter.
Given our reduced loan growth outlook, we expect a lower quarterly build to the ACL in the $25 million to $75 million range, assuming no significant changes in the underlying Moody's economic scenarios. This considers strong production from dividend finance of around $750 million in the third quarter, which, as you know, carries a higher reserve level.
In summary, with our proactive balance sheet management, disciplined credit risk management and commitment to delivering strong performance through the cycle, we believe we are well positioned to continue generating long-term sustainable value for our customers, communities, employees and shareholders.
With that, let me turn it over to Chris to open the call up for Q&A.
