KeyCorp Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
July 20, 2023

There are 11 speakers on the call.

Operator

Good morning, and welcome to KeyCorp's Second Quarter 2023 Earnings Conference Call. As 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.

Speaker 1

Thank you for joining us for KeyCorp's Q2 2023 earnings conference call. Joining me on the call today are Clark Caiatt, our Chief Financial Officer And Mark Bittkiff, our Chief Risk Officer. On Slide 2, you will find our statement on forward looking disclosure and certain financial measures, including non GAAP measures. 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 3.

Speaker 1

Before Clark covers our quarterly earnings results, I want to discuss In our consumer bank, we are growing relationship households at an annualized rate of 5%, Consistent with our Investor Day target, 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 $25,000,000,000 of capital for our clients, placing 18% of the capital raised on our balance sheet.

Speaker 1

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 and A revenue is up from the first half of twenty twenty two. We expect investment banking fees to be up in the second half of the year. One

Speaker 2

common theme across our franchise

Speaker 1

is our Our long standing strategic commitment to Primacy, having our clients' primary operating account, whether it's an individual or a business. Our focus on Primacy is reflected in the quality and diversity of our deposit base. Nearly 60% of our deposits are from retail, small business, wealth and escrow accounts. 80% of our commercial balances are Core operating accounts. Further, 97% of our total commercial deposits are from our relationship clients.

Speaker 1

Importantly, these are long standing relationships. On average, our retail clients have been clients of Key For over 20 years and on average our commercial clients for over 15 years. This quarter, our period end deposits Increased by $1,000,000,000 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.

Speaker 1

Going forward, Key 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 $900,000,000 on an annual basis by the Q1 of 2025. We also continue to be proactive from both Balance sheet optimization and capital allocation perspective, we are well positioned to build capital and reduce risk weighted assets. We will continue to prioritize full relationships and exit non relationship business And non strategic assets. In the second quarter, our period end loan balances declined by $1,000,000,000 We will continue to benefit from our strong fee based businesses, which make up over 40% And naturally reducing our balance

Speaker 3

sheet.

Speaker 1

On the capital front, we will benefit as over 44% of our AOCI We'll roll down over the next 18 months. The next area I would like to discuss is our exposure to credit in the current environment. Credit losses remain relatively low across the industry, but as we move through the business cycle, asset quality will matter. Today, more than half of our C and I loans are investment grade and over 70% of our consumer originations have a FICO score of 760 or greater. These measures reflect the de risking 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.

Speaker 1

B and C Class office exposure in Central Business Districts totaled $121,000,000 2 thirds of our commercial real estate exposure is in multifamily, including affordable housing, which continues to be a significant We also continue to benefit from insights gained from our 3rd party commercial real estate servicing business, As we service over $630,000,000,000 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 Q1 represented over 4% of our expense base Before turning the call over to Clark, I want to take a step back. This quarter, we Strategically built capital, we manage the size of our balance sheet and for the 3rd 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 I will close by affirming my confidence in the long term outlook for our business.

Speaker 1

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 Clark to provide more details on the results for the quarter. Clark?

Speaker 3

Thanks, Chris. I'm now on Slide 5. For the Q2, net income from continuing operations was $0.27 per common share, down $0.03 from the prior quarter and Down $0.27 from last year, driven in part by 2 notable items. Our results included $87,000,000 of additional post tax provision expense in excess of net charge offs or $0.09 per share as we continue to build our reserves. We also incurred $21,000,000 of notable post tax expenses or $0.02 per share.

Speaker 3

This includes severance costs, refunds on fees and related claims and a Visa Class B fair value adjustment. Turning to Slide 6. Average loans for the quarter were $120,700,000,000 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%.

Speaker 3

Compared with the Q1 of 2023, commercial loans grew 1%, While consumer loans remained relatively stable, total loans ended the period at $119,000,000,000 down $1,000,000,000 from the prior quarter. Continuing on to Slide 7, Key's longstanding commitment to Primacy 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 toward minimizing the total cost of funds. Average deposits totaled $142,900,000,000 for the Q2 of 2023, down 3% from the year ago period and were relatively stable across the quarter, Got approximately $500,000,000 on average.

Speaker 3

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 a continuation Regular seasonal outflows that we saw in April were more than offset in May June. Deposits ended the period at $145,100,000,000 up $1,000,000,000 from the prior quarter. Turning to Slide 8, Taxable equivalent net interest income was $986,000,000 for the 2nd quarter compared with $1,100,000,000 in the year ago and prior quarters, Down approximately 11% against both periods. Our net interest margin was 2.12% for the 2nd quarter compared to 2.61% for the same period last year and 2.47% for the prior quarter.

Speaker 3

Year over year net interest income and the net interest margin were by higher interest bearing deposit costs, a shift in funding mix to 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 Q1, Our net interest margin was negatively impacted by 28 basis points related to higher interest bearing deposit costs and 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 and short dated treasuries Turning to Slide 9. As previously mentioned, Key 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.

Speaker 3

Based on the forward curve, we continue to expect a meaningful benefit Currently estimated at $900,000,000 annualized in the Q1 of 2025. We have continued to take a measured but opportunistic approach to lock in this potential benefit and this analysis includes the addition of hedging activity undertaken beginning in 4Q 2022 and 6. We have not and do not plan to replace the swaps rolling off in 2023, instead allowing the natural asset sensitivity of the loan book to come through and benefit from higher short term rates. Moving to Slide 10, non interest income was $609,000,000 for the Q2 of 2023 compared to $688,000,000 for the year ago period and $608,000,000 in the Q1. The decline in non interest income from the year ago period reflects $29,000,000 decline in investment banking and debt placement fees, reflecting lower advisory and syndication fees.

Speaker 3

Additionally, service charges on deposit accounts declined $27,000,000 reflecting previously announced and implemented changes in our NSF OD fee structure And lower account analysis fees related to higher interest rates. The decline in non interest income from the Q1 reflects a $25,000,000 decline in Investment Banking debt driven by lower advisory and syndication fees, partially offset by $10,000,000 increase in corporate services income, reflecting an increase in customer derivatives activity. I'm now on Slide 11. Total non expense for the quarter was $1,076,000,000 down $2,000,000 from the year ago period and down $100,000,000 from last quarter. Compared with the year ago quarter, net occupancy expense decreased $13,000,000 reflecting a downsizing of corporate facilities and business service and professional These decreases were partially offset by a $17,000,000 increase in technology expense and a $15,000,000 increase in personnel expense merit increases and higher benefit costs.

Speaker 3

Compared to the prior quarter, personnel expense decreased $79,000,000 reflecting lower incentive, Stock based compensation and severance. Additionally, other expense decreased $24,000,000 in the 2nd quarter as the Q1 included restructuring charges Moving now to Slide 12. Overall credit quality remained solid. For the Q2, net charge offs were $52,000,000 or 17 basis points of average loans. The delinquencies across portfolio Our provision for credit losses was $167,000,000 for the Q2, which as we have pointed out, exceeded net charge by $115,000,000 For $87,000,000 after tax.

Speaker 3

The excess provision increases our allowance for credit losses to 1.49% of period end loans. Despite 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 2nd quarter with a common equity Tier 1 ratio of 9.2%, Up from the prior quarter and within our targeted range of 9% to 9.5%. This provides us with sufficient capacity to continue to support our relationship customers and their needs.

Speaker 3

We did not complete any open market share repurchases in the segment that are being unnotated to employee compensation, nor do we expect to engage in material share repurchases in the near We will continue to focus our capital on supporting relationship client activity and paying dividends. On the right side of this slide is the expected reduction in our AOCI mark. The AOCI mark 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 with an appropriate comment in the phased and period. Given that, our view is that for any new requirements, our reduction in AOCI marks and more significantly, our future earnings and balance sheet management Q4 of 2023.

Speaker 3

3rd and 4th quarter guidance is given relative to each prior quarter respectively. Similar to our approach in Q3 of last year, we have shifted our guidance to focus on quarterly results. This provides the clearest view of trends heading into year end using the forward curve as of July 1. Balance sheet trends are tracking mostly as anticipated. We expect average loan speed down 1% to 3% in both the 3rd and 4th quarter versus the prior quarter As we continue to actively manage our balance sheet and recycle capital to support relationship clients.

Speaker 3

We expect average deposits to be relatively stable in both 3rd and 4th 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 3rd quarter and be flat to down 2% in the 4th quarter. As we derive more benefit from the repricing of our swaps and treasuries in 2024, we expect growth in both our net interest income and net interest margin. Our guidance assumes a Fed funds rate reaching 5.5% in the 3rd quarter and remaining flat through year end.

Speaker 3

These interest rate assumptions along with our expectations Customer behavior and the competitive pricing environment are very fluid and will continue to impact our outlook prospectively. Non interest income is estimated to be up 2% to 4% in the 3rd quarter and up 4% to 6% in the 4th quarter versus prior periods, reflecting a gradual improvement in capital markets. Non interest expense is expected to remain relatively stable in both the 3rd and 4th quarters. We assume credit Quality remains solid and net charge offs to average loans to be in the range of 20 to 25 basis points in the 3rd quarter and 25 to 35 basis points in the 4th both below our expected over the cycle target range of 40 to 60 basis points. Our guidance for the 3rd and 4th quarter GAAP tax rate is 18% to 19%.

Speaker 3

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 at a GAAP tax rate of 18% to 19%. We feel confident in the foundation of our business, in 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 and A portion of our Operator?

Operator

Thank You will hear an acknowledgment that you've been placed into queue and you may remove yourself from queue at any time by repeating the 10 command. One moment please for the first question. That will come from the line of Scott Siefers with Piper Sandler.

Speaker 4

Good morning, guys. Thank you.

Speaker 3

Good morning, Rusty.

Speaker 1

Hey, Clark, wanted to talk about

Speaker 4

the NII outlook. So the pace of NII degradation looks like it should Slow considerably in the second half, the 4th quarter especially. Maybe a little more color on the main factors you see that would allow that to happen. I know you sort of rationalize The beta expectation, of course, you've got the treasuries and swaps, but just curious to hear from your view sort of main factors in that outlook.

Speaker 3

Sure. Thanks, Scott. And I think this will be a topic worth spending a little time on. So first, let me just remind you that The $212,000,000 NIM would have been $285,000,000 without the swaps and treasuries, which were about $340,000,000 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, it's a little bit of continued decline.

Speaker 3

What I'd say is Fundamentals of our business are very consistent with that comment. What's changed is the rate expectation in the back half of the year. So at that time, We were expecting 2 cuts in the 4th quarter. As I stated in the prepared remarks, we're now going to see kind of a one hike and it 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 And the swaps and the treasuries will be a little bit bigger drag than we previously expected.

Speaker 3

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 flatten and we're Continuing to see swaps mature and the treasury portfolio will begin to mature now in the Q3. So we'll see Opportunity as those two books come off. So what we're seeing then is that flattening of the NII and NIM Trajectory as we go into Q4 and we wanted to reflect that by providing guidance for each individual quarter. As we go beyond that into 2024, I think we'll start to see a pickup.

Speaker 3

Slide 9 isolates the swap and treasury portfolio, so consistent With what we did last quarter, as I stated a few minutes ago, dollars 340,000,000 drag in Q2 or 73 basis points. And the way I think about it just in its simplest terms is $9,000,000,000 of U. S. Treasuries that start maturing in this quarter With basically an average yield, I think, of 45 basis points and $10,300,000,000 of swaps between now and the end of 'twenty four With a received fixed rate between 40 basis points 50 basis points. So put those together, you're looking at close to $20,000,000,000 with an almost 5% You'll pick up by the end of 'twenty four and that's what gets you to the $900,000,000 or $220,000,000 per quarter $230,000,000 sorry Quarter that we have on Slide 9 in the deck as of Q1 'twenty five.

Speaker 3

So 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 want to Touch on that because again, I think it's important to understand. If you look at the 7 $20,000,000 which is equivalent to the $900,000,000 that we quote this quarter, that was consistent with 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 $720,000,000 to $900,000,000 So those are going to move in sync.

Speaker 3

Slide 9 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.

Speaker 4

I don't want to put words in your mouth, but in the aggregate, would your expectation be that NII ends up sort of bottoming around end of Maybe early next year, but then does see a more visible inflection back up as sort of the pricing dynamics wane on funding costs, But you then start to get a more material and visible benefit from the swap and treasury maturities. Is that the best way to think about it?

Speaker 3

Yes. I think that was very well stated.

Speaker 4

Okay. All right. Perfect. Thank you very much. I appreciate it.

Speaker 3

Yes. Thanks, Scott. Thanks, Scott.

Operator

We'll go next to the line of Ebrahim Poonawala with Bank of America.

Speaker 5

Good morning.

Speaker 1

Good morning, Ebrahim.

Speaker 5

Good morning, Chris. Just wanted to follow-up, I think, on the same line of Questioning with Scott around NII. So appreciate the lift from swaps and treasuries. I think The concern when you talk to investors has been the valley before we get to that point has kept getting deeper throughout the year. When we look at this guidance for the back half, I think, Clark, you mentioned implies negative 12% year over year.

Speaker 5

Give us a sense of just level of confidence in that guidance that this 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 industry to handicap this, but any color you can provide would be

Speaker 3

Sure. So look, I think the biggest changes we've gone through the year has been the rate levels. Given your commentary on sort of relatively stable rates, I think we feel very good about the trajectory we're sharing here. And I would say, Overall, our deposit betas 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 Treasuries, but again as those come off, we think we're prepared to get the benefit of that.

Speaker 3

So I would say that In the expected rate environment, our confidence would be good.

Speaker 5

Got it. And second question, I think Chris talked about 2 things. 1 is Focus on expenses, I see the guidance for flat expenses for the back half. Give us a sense if there's a bigger opportunity here on Flexing expense leverage as we move into back half and as it leaves the Street thinks about 2024 EPS and also around any proactive RWA Actions, I think you mentioned getting rid of or exiting non strategic relationships. How impactful could that be for character capital?

Speaker 1

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 all the regs unfold. What's not going to change For us, Ebrahim, is we're going to remain focused on our relationship model. We're going to stay focused on targeted scale.

Speaker 1

But I think there's going to be incredible and intense Scrutiny around the duration, the granularity, the composition of the deposit base and that's one of the reasons That Clark 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 to I think there's going to 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 this through your models and we run it through our models, I think loan to deposit ratios For Category 4 banks, if they're mid-80s 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, like around 19%, I should say, high teens.

Speaker 1

And then we were on a path to grow 6% to 9%, but that all happened in the Q1 before the events of March. And we not only Stop that growth, but actually pushed it back $1,000,000,000 by the end of this quarter, which I think is really, really important. And right now what we're doing 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, then you can rest assured there'll be a lot of credit only Relationships that won't be strategic to us.

Speaker 1

So we'll 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. And you see in the guidance That Clark gave you, we're looking at average loans being down 1% to 3% in the 3rd quarter and down 1% to 3% in the 4th 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.

Speaker 1

And rest assured, we're looking at that as well. And

Speaker 5

then Chris, if I may squeeze one in. Just give us a sense of the dividend. There's been a lot of focus, the 7% dividend yield. As the Chairman of the Board, I know it's evaluated every quarter, but how confident are you in terms of dividend sustainability as we Kind of plug through the back half into 2024.

Speaker 1

Sure. Well, the headline there is I am confident. But 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.

Speaker 1

It's to support our clients, our prospects And to pay dividends. And to your point, last week, our Board did approve a $0.205 3rd 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 a cash dividend. So we're obviously paying close attention to that.

Speaker 1

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 $0.205 dividend and we built reserves. And so as we think about taking this long term perspective, When you look at our 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.

Speaker 1

Clark mentioned the AOCI burn down, 44% by Twelvethirty onetwenty four, 55% by Twelveth 3,125. 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 is we have a well positioned credit book. And there's 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.

Speaker 1

We take a long term perspective on the dividend. We feel good about it.

Speaker 5

All very helpful color. Thank you so

Speaker 1

Sure. Thank you, Ebrahim.

Operator

We'll go next to the line of Ken Usdin with Jefferies.

Speaker 6

Hey, guys. Just a couple of follow ups on the loan side. Obviously, you said that you're retaining a little Go back to kind of that upper teens point of your investment banking originations. And I'm just wondering, Does that have any throughput 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 to 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?

Speaker 1

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 debt in the 2nd 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.

Speaker 1

But the premise of your question, as we look to shrink our balance sheet, The ability to distribute paper to a lot of different places will be will in fact be important. And so that will be an In terms of what I'm seeing, here's kind of what I'm seeing. 1, our M and 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 It's not that I'm seeing things coming out of the pipeline.

Speaker 1

Obviously, in the equity market, we're starting to see that. You're seeing that Sure. But what I'm really pleased with is I talk to our clients all the time. In fact, as recently as yesterday, I talked to one of our large clients We're 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 just for so long.

Speaker 6

Got it. And just one more. Laurel Road, some cross factors there too, obviously with the debt moratorium and what happens there. But just as far as also Being scrutinizing every incremental loan that you're making, just can you talk about the Laurel Road specifically, but how you're also Thinking through that in terms of the other consumer portfolios?

Speaker 1

Sure. I'll start and then I'm going to flip it over to Clark. But it's a great question and it's 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 have. Before we bought Laurel Road, They securitized and distributed 100% of their loans.

Speaker 1

Going forward, we're going to be securitizing and distributing There are loans. 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 Laurel Road, The other thing we've done on Laurel Road is we've really made 2 pivots in what's been going on with the federal student loan payment holiday. 1, We turned it into a complete digital platform whereby we can have loans, deposits, Importantly, checking account, card, mortgage, etcetera.

Speaker 1

The other thing that we did is when we bought Gradfin and we're in the early days of this, Ken, But Gradfin 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 that's another pivot that we've made there. But getting back to your question about sort of our asset light model, Mark, why don't you talk about speak to that particularly around mortgage as well?

Speaker 3

Yes. So I think largely we're going to look To continue to distribute, I mean, we do have capabilities now where we distribute a lot of debt. We're going to expand that more consistently I think to the consumer side. The point I think on 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.

Speaker 3

It was intended to be a full service banking platform. We continue to build toward that and we think it's got some really Unique and differentiated capability around this income driven repayment and public service loan forgiveness and you may have seen Some commentary out of the government in the past week around the IDR specifically and some of the complexities of that, which I think We'll accrue to our benefit over time.

Speaker 6

Got it. So if I can wrap that together, is it fair to say that the trade off of Less NII, less loan growth over time getting the LDR down, you'll sacrifice some NII Help on the capital side and then move towards more of a fee generating model? Just in term, yes.

Speaker 3

Yes. I think that's the right idea. I think we're also demonstrating more deposit growing capability there. And again, we're still relatively new in having those capabilities. But I think that's the right way to think about it.

Speaker 3

So more of a fee advice and core banking generator than a loan shot.

Speaker 6

Okay. Got it. Thank you.

Speaker 3

Yes.

Operator

We'll go next to the line of John Pancari with Evercore. Please go ahead.

Speaker 1

Good morning. Good morning, Jeff.

Speaker 3

Good morning.

Speaker 7

Just going back to the $900,000,000 on Slide 9 of the NII pickup from Treasury and swap maturities.

Speaker 5

So let me just ask it

Speaker 4

this way.

Speaker 7

Aside from A change in the rate backdrop and 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 $900,000,000 to find its way into the numbers. From your perspective, how do you size up the risks? What are the risks that you do not realize that? What gets in the way?

Speaker 7

Is it more on the deposit side Or is it an asset side of the picture that could prevent that from being realized?

Speaker 3

Yes. So I think, I mean, the rate Available when the treasuries and swaps mature is sort of the single biggest factor and that would be would have been reflected The $720,000,000 moving to $900,000,000 So and again, that's 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.

Speaker 3

Over time, if there's 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 of lower beta expectations at the end of Q1 when we showed you a $720,000,000 opportunity, Higher beta expectations here today, but that opportunity has gone up kind of in a related way. So I don't know and I don't want to pretend those are kind of 1 to 1 tied, but I would think about those moving at least in a fairly correlated direction.

Speaker 7

Got it. Okay. All right. Thank you. And then separately, as you continue to exit the or as you're evaluating Nonstrategic Businesses and Other Optimization, just to confirm, any progress you make incrementally on that That would be in addition like to the guidance of a decline of 1% to 3% on the loan front.

Speaker 7

So anything on the Incremental optimization that would provide or that would lead to potential incremental downside to these numbers?

Speaker 3

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've built into this guidance is how we're running the business right now.

Speaker 7

Okay. All right. Thank you.

Operator

We'll go next to the line of Matt O'Connor with Deutsche Bank.

Speaker 4

Good morning. I want to follow-up on the kind of capital line of questions.

Speaker 1

I guess the first thing is, a lot

Speaker 4

of your peers seem to be targeting 10% plus On the CET1, obviously, there's capital proposals coming out. But I guess, First question is what are your thoughts in terms of that 9% to 9.5% target moving closer to 10% to 10.5% like some

Speaker 3

of your peers?

Speaker 1

So Matt, we think 9% to 9.5% is the right number for us given our business mix. If you think about 50% of our C and 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 at Funding, we have FICO scores in our consumer business of 760 or so. We think it's the right number. And obviously, at 9.2% and having grown it from 9.1% this quarter, we're right in the strike zone.

Speaker 1

Having said all of that, we like everybody else, we'll wait and digest anything that Comes out in the not too distant future and reevaluated at that point. But for our business, right now, We feel that's the right number.

Speaker 4

Okay. And then in terms of the RWA optimization, is it possible to size that or give a range and The timing of when you'll get the benefit of that?

Speaker 1

We're looking at a lot of different things. Right now, I'm most comfortable just directing you to the guidance that we gave around loans. But as I mentioned, we're looking at other things as well. I'll leave it at that.

Speaker 4

Okay. Thank you.

Speaker 1

Thank you, Matt.

Speaker 5

We'll go

Operator

next to the line of Manan Goslia with Morgan Stanley.

Speaker 2

Hi, good morning. I wanted to clarify your comments earlier on the call that you believe that the LDRs for the And Category 4 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 TLAC rules to also apply for Category

Speaker 3

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 Q2. So I think your follow on question around TLAC or long term debt is the right one as well and we'll wait as Chris just mentioned for The proposed and final rules, but we do think that reduction in loan to deposit over time gives us an opportunity to Reduce reliance on Wholesale funding.

Speaker 2

Got it. Okay. And then maybe on the credit side, Given the ACL was up this quarter as well, was that entirely model driven? And I guess how much of a buildup is there more of a buildup to do? And What sort of an environment do you have baked into that current reserve ratio?

Speaker 1

Sure. So just from a CECL perspective, obviously, it's very forward looking. In terms of what percentage is model driven, what percent is kind of 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.

Speaker 1

I think it will probably happen in 2024. Having said that, what I don't think is yet in the market is the Impact of all the rate increases and also the impact of banks tightening 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 is leveraged and anything Where the cash flows could be in any way impacted by a slowing economy.

Speaker 1

So that's kind of the lens that we looked at it. There is Nothing specific. There's nothing that we're particularly worried about. We kind of looked across all the portfolios.

Speaker 2

So as we if we do move towards a soft landing, would that imply that you don't Need the ACL ratios to really move higher?

Speaker 1

Yes. Right now, I feel like we have reserved what we need to reserve for sure.

Speaker 2

Got it. Thank you.

Operator

Thank you. We'll go next to the line of Mike Mayo with Wells Fargo Securities.

Speaker 8

Hi. Can you hear me?

Speaker 1

Yes. Mike, we can. Good morning. Okay. Good morning.

Speaker 8

So you're guiding NII down 4% to 6% in the 3rd quarter and another 0% to 2% in the 4th Quarter, what does that mean for your NIM even in broad terms? I guess it was 2.12% in the second quarter?

Speaker 3

Yes. We would expect it to be relatively flat in the Q3 and then start to trend up.

Speaker 8

Okay. So My question is, look, that's the lowest core margin possibly ever, at least since the global financial crisis. I mean, And it's such a slim margin here. And then, so I guess, Why such as low margin and even after the increase, I guess I get to around NII of about $1,150,000,000 per quarter, which is where you were in the Q2 of 2022, Which is before the Fed rate hikes. And you can correct the math, but you're using the midpoint, your NII of 9.86 It goes down to $937,000,000 next quarter and then $927,000,000 in the 4th quarter.

Speaker 8

And then I guess you're saying it Goes up by about 1 fourth from there by the end of the year, right? So, dollars 9.27 plus 1 fourth of that $900,000,000 annualized gets you around Yes, 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 that's at a level before the Fed rate hikes. So even with the potential improvement next year, which would be an incremental positive, You're still not getting credit for any of the February hikes that took place. So what happened with the structural positioning of the balance sheet That leads to such a low NIM and NII.

Speaker 3

So I mean, what I where I'd 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 and 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 or personal consumer loans, which we have very little exposure to. So In that regard, we're starting probably structurally from a little bit lower NII, but the counter So that is what we think is higher credit quality book. So, I'll have to go back through the specific math you have there, but And I'm happy to do that and talk about it offline, but I think that's at least a starting point.

Speaker 3

But we think Over time, a NIM that starts with a 3 is not an unreasonable place for us to be.

Speaker 8

And so is that right? So next year, you're guiding basically from the Q4 level where it stabilizes, At least the NII should go up by about 1 fourth by the end of the year. In other words, you're guiding basically close to $900,000,000 for the Q4 or a little above. And then you're saying you're gaining $900,000,000 annualized by the end of next year. So that would imply NII would go 1 fourth higher from that 4th quarter level, All else equal, is that correct, the logic?

Speaker 3

Not exactly. So the $900,000,000 is annualized as of the Q1 of

Speaker 8

2025. Okay. So just a little bit later, got it. But eventually that NII goes up

Speaker 3

by 1

Speaker 8

fourth. And I said the words all else equal, what would not be equal? What could help the NII and what could help that NIM Go back from 2% to 3%, what is that logic missing?

Speaker 3

Well, I think it's I mean, the obvious One right there is the 73 basis points that comes from swaps and treasury, so that's what we're talking about. And beta is I think getting Or general rates and beta is 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 there's a variety of factors that could improve that, Many of which we are either not experienced at the moment or haven't seen, kind of broadly in the industry.

Speaker 8

And then last one. Chris, you started off saying you expect Investment Banking to be stronger in the second half of the year. There's been some drought for the industry. What gives you confidence either for the industry, For key or for both?

Speaker 1

Mike, I was just I mentioned this earlier in the conversation. It is based on my experience being around this business as long as I have. People will defer transactions for so long, but eventually sort of the logjam starts to break. I think we're starting to see it a little bit in the 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 they're going to move on and do something else.

Speaker 1

So it's based on, 1, just looking and scrutinizing the backlog and then secondly, just More instinctive as I'm out talking to people.

Speaker 8

So Fisher Cup date time?

Speaker 1

Yes, for sure.

Speaker 8

Okay. Thank

Speaker 1

you. Thank you, Mike.

Operator

We'll go next to the line of Erika Najarian with UBS.

Speaker 9

Hi. First question for hey, what was your adjusted CET1 in the Quarter, including AOCI. And I presume that 9%, 9.5% CET1 target would be Like your fully loaded target even after we get an NPR that would be inclusive of AOCI and CET1?

Speaker 3

Yes. So whatever that ultimate target is, Erica, will reflect the appropriate rules. So if the AOC opt out It is eliminated then yes, I think you stated that correctly. So, 630, that level for AOCI AFS is about 6:30.

Speaker 9

Got it. So my second question is for you, Chris. And 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 dividend fears that were in the market given where your yield is. And I think the big discussion I'm having with your investors That 80% payout, right, that you mentioned and that happened for this quarter, It feels like 3 years ago sort of in the pandemic, you were getting the same questions about the sustainability of your dividend. And it feels like at the end of the day, it's really the denominator that has been challenged.

Speaker 9

So whether it's been Expenses previously or having the balance sheet set up to have these received fixed rates that essentially implied a zero rate environment forever, it just feels like your efficiency ratio isn't just quite right and doesn't really reflect the potential

Speaker 5

of the

Speaker 9

business. So as you think about the next 3 years, how are you what discussion are you going Have with your Board to have that earning the potential of your franchise really be reflected in your earnings power. I mean, the NIM is the NIM and I get to I feel like that gets wrapped up in the dividend conversation the entire time, not necessarily because the dividend is an albatross, But it feels like that your earnings power is so sensitive to vagaries of the macro.

Speaker 1

Well, first of all, I appreciate the question. I 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 challenge is our business is performing well. We clearly are under earning and we're under earning based on how we have our balance sheet positioned.

Speaker 1

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 that's driven by something else. But what we really need is the position 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. And the passage of time will do a lot on that. Unfortunately, It is the passage of time, but as I mentioned, the burndown is 44% between now and Twelvethirty onetwenty 4 and 55 This is as it relates to AOCI by Twelvethirty Onetwenty 5.

Speaker 1

So that is the issue. And I think we are said differently, We are under earning right now and we will be over earning as the position unwinds and rolls down.

Speaker 9

Got it. Okay. Thank you.

Speaker 1

Thank you.

Operator

And we'll go next to the line of Gerard Cassidy with RBC.

Speaker 5

Chris, you touched on

Speaker 7

in your opening remarks about this Commercial Mortgage Servicing Portfolio, I think you said it's $630,000,000,000 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 CMBS market, I suspect your special servicing business has picked up and maybe some color there?

Speaker 1

Sure. Well, thanks for the question. It's a great business. It's a great business because it generates a bunch of deposits through escrows, which are More important today than they ever have been in my career. It's also important because it's countercyclical.

Speaker 1

So for those of you that aren't as familiar with the business, We are the named special servicer when a large complex debt financing is put together. And So when you're 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 off us real estate, We are the workout agent. And to Gerard's point, we just set for the 2nd quarter in a row A record in terms of special servicing fees. And so, I think that will continue and this won't surprise you, Gerard, but More than 2 thirds of what is in active special servicing is office.

Speaker 1

And I think that's going to continue and I think office is going to be it's not going to be a challenge for Key because it's not an asset class we focus on, Well, I think office is going to continue to be a significant challenge.

Speaker 7

And Chris, based on your experience with this, These fees stay with you for a while since the workout phase takes quite a bit of time.

Speaker 1

Yes. These are very large 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 to be $5,000,000 $6,000,000 $7,000,000

Speaker 7

Great. And then sticking with this, can you share with us just on commercial loans, not 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 soft landing is what you're thinking, but if the economy does lead to more delinquencies and defaults, what are you guys doing now to get in front of that?

Speaker 1

This is an area where we spend a lot of time. We are as it relates to the C and I book, Particularly focused on anything that has floating rate debt that's leveraged. And so for us, Our leverage book literally 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 we are there's a lot of us, Mark Mitkip's in the room with me, who's our Chief Risk Officer. He and I and others are laying eyes on this.

Speaker 1

We feel really good about where the portfolio is. But anytime you go into an environment where you have Declining EBITDA and a business with a lot of leverage and the cost of capital going up, you 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 that's where I spend some of my time because that's what's most vulnerable.

Speaker 3

Thank you.

Speaker 1

Thank you, Gerard.

Operator

And we'll go next to Steven Alexopoulos with JPMorgan.

Speaker 10

Hi, good morning, everyone.

Speaker 1

Good morning, Steve Alexopoulos.

Speaker 10

I wanted to first follow-up on your answer, Chris, to Ebrahim's Question. Are you signaling that the door is not open at all in terms of potentially rightsizing the dividend?

Speaker 1

I wouldn't say it's not open at all. The reason I would put that caveat is I've yet to see the new capital rules. But what I'm saying is I'm very comfortable with our dividend payout in the

Speaker 10

And then On the fee income guide, I heard the messaging around Green Chutes and Capital Markets. But are those really needed to get us to this range, Right. The up 4% to 6% and then sorry, up 2% to 4% and then 4% to 6%. Are there other factors which give us some cushion if the IBVs don't come back that

Speaker 1

There's other areas where we have cushion, but I mean investment banking Fees are a big component of that and we need to have more trajectory in the back half of the year on investment banking We did in the front half of the year in order to hit these numbers.

Speaker 10

Got it. Okay. And then finally, just big picture view, obviously a lot of questions on the NIM. I'm This is Mike saying 212. For Clark, how do you think about managing the balance sheet and interest rate risk Differently, so you don't get in this situation again where the NIM is as low, dividend payout ratio is as high, you're missing on NII guidance, which is really all tied to what we're seeing on the swaps.

Speaker 10

But how do you think about big picture, so once you do get into a 3% NIM range So that you sort of hang around there. Thanks.

Speaker 3

Yes. It's a great question. I 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 direction and pace of rate movements. So I think if rates had moved in an orderly fashion, this would be much less of an issue. They did not, as you know, and I think we just have to be More dynamic in our thinking about putting on certain positions.

Speaker 10

Got it. Okay. Thanks for taking my questions.

Speaker 3

Yes.

Operator

Thank you. And there are no further questions in queue at this time. I'll turn it back to Mr. Gorman.

Speaker 1

Well, thank you so much, operator. Thank you for participating in our call today. If you have any follow-up questions, you can direct them to our Investor Relations team, 216 689-4221. This concludes our remarks. Thank you, everybody.

Speaker 1

Have a good afternoon or good morning.

Operator

Thank you. And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation and for using AT and T event conferencing. You may now

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Earnings Conference Call
KeyCorp Q2 2023
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