Keycorp (KEY) — Q2 2017 Earnings Call Transcript

Thank you, Operator. Good morning, and welcome to KeyCorp's second quarter 2017 earnings conference call. In the room with me is Don Kimble, our Chief Financial Officer, and we announced in June that Chris Gorman and Don were both recently named Vice Chairman of our company; and as such, we have Chris Gorman here joining us today in his new capacity as President of Banking at Key. Slide 2 is our statement on forward-looking disclosure and non-GAAP financial measures. It covers our presentation materials and comments as well as the question-and-answer segment of our call. Now I will move to Slide 3. This morning, we reported second quarter earnings of $393 million or $0.36 per common share. Our quarter included a number of notable items that we have outlined on the slide, which in total contributed a net benefit of $0.02 per share. Overall, it was another strong quarter, which reflects our continued business momentum across the company and the realization of value from our First Niagara acquisition. In the second quarter, excluding notable items, we generated positive operating leverage of 10% compared with the year-ago quarter, driven by revenue growth from our acquisition as well as our core businesses. Revenue benefits from both higher net interest income and continued growth in our fee-based businesses. On a linked quarter, expenses remained relatively stable despite some seasonal increases in certain line items. And importantly, we reached $400 million in annual run rate cost savings from our First Niagara acquisition. We remain confident in achieving $50 million in incremental savings by early 2018, which will allow us to continue to deliver value to our shareholders. Our cash efficiency ratio, excluding notable items, was 59%, and our return on tangible common equity moved to 13%. Credit trends remained strong during the quarter, with net charge-offs of 31 basis points and nonperforming loans down 12% from last quarter. In the second quarter, we increased our common stock dividend by 12% and continued repurchasing shares. We also received no objection from the Federal Reserve on our Capital Plan, and we are particularly pleased to highlight that it included two additional dividend increases in the plan period. By the second quarter of next year, this would result in a dividend of $0.12 per share or a 26% increase from the current level, obviously subject to board approval. Moving to Slide 4. We've continued to make investments in our talent, products and capabilities to drive growth, which contributed to our strong results this quarter. I've already mentioned the contribution of First Niagara, but we still have opportunities to reduce expenses further and deliver meaningful revenue synergies. I remain very confident in our ability to achieve the remaining $50 million in cost savings by early next year, bringing the total to $450 million or 46% of First Niagara's full year 2015 expense base. And we've been pleased with our initial success in generating incremental revenue in areas such as commercial mortgage banking and payments. Over the next several years, we expect to reach $300 million in annual revenue synergies. The investments we have made across our businesses have also helped fuel record results in our fee-based businesses like investment banking and debt placement, which reached $575 million on a trailing 12-month basis. Cards and payments income have also grown significantly with compounded annual growth of 18% over the last three years. These two businesses have generated more than $300 million of combined revenue growth over the past three years, and more than 80% of that has come from our core business and the investments we have made at Key, in our people, products and capabilities. These businesses were also identified as opportunities for First Niagara revenue synergies, and we are still in the early stages of those being realized. And importantly, we are continuing to look across our organization and make strategic investments that will drive future opportunities for us. We recently announced the acquisition of HelloWallet, which has been a core component of our financial wellness offering. This acquisition further embeds HelloWallet into our platform, enhances the consumer value proposition and provides us with improved data and analytics. We will also fully control the investment roadmap and continue to strengthen and tailor HelloWallet's capabilities to help our 3 million clients improve their financial wellness. We also repositioned our merchant services business by acquiring our clients from a previous joint venture, which resulted in a $64 million gain during the second quarter. Our actions ensure we can best serve our clients with our direct relationship strategy going forward. This also better aligns our economics with the performance of the business and our clients. I believe these examples are illustrative of our enterprise-wide approach to continue driving and improving the value we provide our clients and our shareholders. I will close my portion of the call by restating my earlier point that it was another strong quarter for Key, demonstrating the value of our First Niagara acquisition and the core momentum we have built in our company. And this is translated into stronger operating results, a cash efficiency ratio of 59% and a return on tangible common equity of 13%. With that, I will turn the call over to Don for a more detailed look at the quarter.

Thanks, Beth. I'm on Slide 6. We reported second quarter net income from continuing operations of $0.36 per common share. This compares to $0.23 per share in the year-ago period and $0.27 from the first quarter. As Beth mentioned, our results this quarter included a net benefit of $0.02 per common share from notable items made up of a $64 million one-time gain in our merchant services business, a benefit of $43 million from the finalization of purchase accounting, merger-related charges of $44 million and a $20 million charitable contribution. Earnings per common share, excluding these items, grew compared to both the prior quarter and the prior year. As Beth highlighted earlier, excluding notable items, our cash efficiency ratio was 59.4%, and we had a return on tangible common equity of 12.9%. Over time, we have seen continued improvement in these metrics. And with our second quarter results, we are either at or approaching our stated long-term targets. I will cover many of the remaining items on this slide in the rest of my presentation, so I'm now turning to Slide 7. Total average loan balances of $87 billion were up $25 billion or 41% compared to the year-ago quarter and up $369 million or 0.4% unannualized from the first quarter. Compared to the year-ago period, average loan growth primarily reflects the impact of the acquisition as well as ongoing business activity, with commercial and industrial loans continuing to be a driver. Sequential quarter growth in average balances was driven by commercial and industrial loans, which were up 1.7%, and offset lower commercial real estate and consumer balances. Our geographically-based core relationship business performed very well in the second quarter. Overall, our Community Bank middle market lending grew 4% un-annualized linked-quarter, with broad-based growth across Key's franchise, including strong loan production coming from our new and overlapped markets in the Northeast. In our Corporate Bank, client dialogue and deal flow were strong across the board. We raised a significant amount of capital for our clients, but we did see a mix shift towards capital markets' alternatives, which muted our loan growth. During the second quarter, only 14% of the capital we raised went onto our balance sheet, as capital market alternatives remained attractive for our clients. As an agent, we were able to meet the needs of our clients and generate strong fee income, as evidenced by our investment banking and debt placement fees. In real estate specifically, this mix shift was visible, with over $400 million in balances moving off our balance sheet during the second quarter and into the capital markets. I would also note that we continue to be selective in commercial real estate, having stepped back from certain markets and asset classes while also keeping the size of our construction book relatively small. Consumer loans primarily reflected the continued decline in the home equity portfolio, largely a result of pay-downs during the quarter. Our guidance for the year remains in the $87 billion to $88 billion range for the full year average balances. We project being at the lower end of the range, with an increase in commercial loan growth in the second half of the year. Continuing on to Slide 8. Average deposits totaled $103 billion for the second quarter of 2017, an increase of $29 billion or 39% compared to the year-ago period, and up $700 million or 0.7% unannualized compared to the first quarter. Cost of total deposits was up 3 basis points from the first quarter, as commercial deposit pricing gradually moved higher for select relationships. We also saw growth in higher-yielding deposit products. Overall, our deposit betas continue to remain below historic levels, as we are maintaining our pricing discipline in our markets. Compared to the prior year, second quarter average deposit growth was driven by First Niagara as well as core retail and commercial deposit balances. On a linked-quarter basis, the change in deposit balances was primarily driven by core growth in CDs, NOW and MMDA, partially offset by a decline in escrow balances. Consumer deposits, which include our retail franchise as well as the small business and private banking, now account for 60% of our total deposit mix. Turning on to Slide 9. Taxable equivalent net interest income was $987 million for the second quarter of 2017, and the net interest margin was 3.30%. These results compare to the taxable equivalent net interest income of $605 million and a net interest margin of 2.76% for the second quarter of 2016, and $929 million and a net interest margin of 3.13% in the first quarter of 2017. Included in the second quarter net interest income is $42 million from the finalization of purchase accounting, which added 14 basis points to our net interest margin for the quarter. Excluding the impact of the finalization, accretion contributed $58 million or 19 basis points to our second quarter results. This compares to $53 million or 18 basis points in the first quarter. Our outlook for the second half of the year assumes approximately $5 million of correlated decline in each of the next two quarters, resulting in approximately $100 million of accretion in the second half of the year. Excluding purchase accounting accretion, net interest income increased $282 million from the prior year, largely driven by the impact of First Niagara and higher earning asset yields and balances. Growth of $11 million from the prior quarter resulted from the higher earning asset yields, which was partially offset by higher funding costs and lower loan fees. Excluding the impact of purchase accounting accretion, our net interest margin was 2.97% for the second quarter, up 2 basis points on a linked-quarter basis, as the benefit from higher interest rates more than offset funding costs and loan fees. With finalization of our purchase accounting, our slide also now includes the remaining loan mark, which stood at $345 million at June 30, and the remaining PCI accretable yield of $137 million. Moving to Slide 10. Non-interest income in the second quarter was $653 million. Excluding notable items, which includes a one-time merchant services gain and a small benefit from purchase accounting finalization, noninterest income was $592 million, up $119 million from the prior year and up $15 million from the prior quarter. Growth from the prior year reflects the impact of the First Niagara acquisition as well as continued business momentum and investments across our franchise. Investment banking and debt placement fees increased $37 million, driven by higher commercial mortgage banking, underwriting and advisory fees. Compared to the first quarter, the $15 million increase in non-interest income largely reflects an $8 million increase in investment banking and debt placement fees. Operating lease income and other leasing gains increased $7 million, and cards and payments related revenues increased $5 million. Turning on to Slide 11. Reported noninterest expense for the second quarter was $995 million, which includes $44 million of merger-related charges and $16 million of other notable items, a charitable contribution and a small benefit from purchase accounting finalization, both of which were in other noninterest expense. Our expense level this quarter reflects our commitments to reduce expenses and improve efficiency. As Beth mentioned, during the quarter, we reached $400 million of annualized cost savings. And as we look out to the second half of 2017 and into early 2018, we will be executing on the remaining incremental $50 million to reach our full target of $450 million. Compared to the second quarter of last year, and after adjusting for notable items, noninterest expense was up $229 million. Growth primarily reflects the acquisition of First Niagara as well as higher incentive compensation related to stronger capital markets performance. Linked quarter expenses adjusted for notable items were up $3 million. Second quarter expense levels mostly reflect normal seasonal trends, including increased marketing efforts. Turning to Slide 12. Net charge-offs were $66 million or 31 basis points of average total loans in the second quarter, which continue to be below our targeted range. Second quarter provision for credit losses was also $66 million, matching the level of charge offs. Non-performing loans decreased $66 million or 12% from the prior quarter and represented 59 basis points of period-end loans. At June 30, 2017, our total reserve for loan losses represented 1% of period-end loans and 172% coverage of our nonperforming loans. Turning to Slide 13. Our common equity Tier 1 ratio at the end of the second quarter was 9.97%. As Beth mentioned, we increased our quarterly common dividend by 12% to $0.095 per share. And in accordance with our 2016 Capital Plan, we repurchased $94 million of common shares during the second quarter. We also had no objection to our 2017 Capital Plan, which includes two common share dividend increases, reaching $0.12 per common share in the second quarter 2018, as well as a common share repurchase program of up to $800 million. Slide 14 provides you with our outlook and expectations. We remain committed to generating positive operating leverage and have updated our guidance to reflect our second quarter results. Consistent with our previous guidance, our outlook does not include merger-related charges. Based on our results in the first half of the year, we expect full year average loans to be in the low end of our $87 billion to $88 billion range, driven by strength in C&I. Average deposit balances for the year will reflect the expected run-off of some non-core deposits from the second quarter and should be in the range of $102.5 billion to $103.5 billion. Net interest income is expected to be in the range of $3.8 billion to $3.9 billion, marking an increase from our previous guidance to reflect the impact of higher interest rates and purchase accounting accretion. Our outlook assumes no additional rate increases this year, and the betas will remain well below their historic levels. We continue to expect quarterly impact of purchase accounting accretion to trend down over time, with the second half of the year totaling approximately $100 million. The quarterly impact should decline at a consistent pace from the second quarter level of $58 million, a decline of about $5 million a quarter. We anticipate that noninterest income will be in the range of $2.35 billion to $2.45 billion, an increase from our prior guidance, reflecting the second quarter merchant services gain as well as continued growth from our ongoing business activity and the acquisition. Noninterest expense should be in the range of $3.7 billion to $3.8 billion, which includes the impact of merchant services and HelloWallet. We expect merger-related charges, which are not included in the guidance, to trend down in the second half of the year from the second quarter level. 2017 net charge-offs should continue to be below our targeted range of 40 to 60 basis points, and provisions should slightly exceed our level of net charge-offs to provide for loan growth. Our GAAP tax rate is expected to be in the 26% to 28% range for the full year, reflecting a higher marginal rate on incremental earnings. And we remain committed to our long-term financial targets on the bottom of the slide: continuing to generate positive operating leverage, operating at a cash efficiency ratio of less than 60%, maintaining our moderate risk profile and producing a return on tangible common equity in the 13% to 15% range. I'll now turn the call back over to the operator for instructions on the Q&A portion of the call.

Regarding the loan growth guidance being at the lower end of the 87 billion to 88 billion range for average loans, I think you ended average loans at the midpoint of the year at 86.3 billion, right? That implies only 340 million a quarter for growth for the second half, which is relatively soft. Is the drag from home equity loans driving this outlook for more muted growth? Or is something else going on?

Well, Steve, for us to get to $87 billion, starting with an 86.3 for the first half, that means we'd have to be at $87.7 for the second half of the year. And so it would be a fairly sizable loan growth and a pickup from what we've been experiencing in the first half of the year.

Okay. Got you, Don. Okay. With the deposit costs ticking up quarter-over-quarter, Don, how are you thinking about the core margin here, ex the purchase accounting adjustments?

Yes. We're showing a 2.97% for the current quarter without purchase accounting, that's up 2 basis points from the last quarter. It really reflects about 3 basis points from the March beta impact as far as the rate increase, offset by about a basis point lower from loan fees. And so going forward, we would expect to see some lift again in the third quarter from the June rate increase, that we would continue to expect to see a lower impact from purchase accounting accretion in future quarters.

Do you think deposit costs keep trending higher at the pace we saw this quarter?

I think that there's a couple of things that impacted us this quarter. One was the impact of the rate increase, but also we saw a mix shift in the current quarter. And so our outlook wouldn't imply the same type of mix shift going forward, but we would expect to see some of the same impact I talked about before as far as the June rate increase, and then also the purchase accounting adjustment.

And then just a big-picture question for Beth. With the full First Niagara cost saves now in, the additional $50 million is on track, what do you think about what's next for Key? Do you do another bank deal here? Do you keep doing small deals, such as HelloWallet? What's the playbook?

We've always said that we would invest in people, products and capabilities. And I think this quarter was the reposition of our merchant servicing and the purchase of HelloWallet because that's very consistent with our strategy and our actions over the last couple of years. We've also said that, obviously, we felt First Niagara was a compelling opportunity and a unique fit for Key. And at the time, many banks talk about acquisition for scale, acquisition to reach a certain size. We have never talked about our strategy or our playbook in those terms. We've always said we have a full complement of what we need to serve our customers. But as we looked at First Niagara, we did believe it was a compelling fit. And as we sit here today, I do believe it was a good use of capital and has indeed created real value for our shareholders. So we are not yet done realizing the value. While we have realized the $400 million, we do have additional expense synergies. We're working on the client and revenue synergies. I don't believe we need further acquisition to meet our long-term goals. But I've also learned to never say never. But I believe that our strategies are sound, our focus is clear, and that we're creating real value for our shareholders.

I just wanted to get a little bit of additional color on loan growth trends that you're seeing. On the CRE side, I know you indicated some of the impact of the permanent financing markets. Does that imply that the front-end production on real estate generation is slower, at least on the construction side, and if you can talk about that a little bit? And then on the C&I side, I'm not sure if you mentioned line utilization. Sorry if I missed it. And just really interested in what you're seeing there in terms of CapEx pickup at all at your borrowers, and if that's driving a pickup in demand at all.

So a couple of things, as it relates to our CRE business, we still are seeing a lot of flows. If you look at our commercial mortgage banking business, we're up significantly year-over-year, and the pipelines are up. So there's a lot of flow within our real estate business. But as Don mentioned and Beth mentioned, there's a bit of a mix shift, that which goes on the balance sheet and that which we place elsewhere. So good flows in real estate, but the reality is there are market opportunities for our clients as these debt markets are wide open, and we're taking advantage of those for the benefit of our clients. With respect to risk management in real estate, we've talked before about keeping the portion of which is construction to a pretty low percentage, in this instance about 13%, and that's by strategy. And the other thing we've talked about, gee, for a couple of years on this call, is there are certain categories in certain locations, multifamily, gateway, gateway cities, for example, where we've been, from a risk profile, for some time sort of moderating our exposure there. With respect to your question on utilization, our utilization is really up a de minimis amount on a linked-quarter basis, about 0.5%. It doesn't necessarily show up particularly in CapEx as we think about our clients. Our clients remain optimistic. The discussions we're having with our clients remain very, very strategic and focused, but we are not seeing a whole lot of capital expenditures at this point.

That's helpful. For my follow-up on Steve's M&A question, Beth, it seems you're still considering strategic fits, particularly favoring smaller nonbank deals. As for bank deals, it appears you haven't completely dismissed them, especially if something compelling arises. My concern, which aligns with investors' worries, is regarding earn-back. The long earn-back period for tangible book value in the First Niagara deal was a significant issue for investors. How do you view the earn-back metric now? Would you consider a similar timeframe as in the First Niagara deal, or are you aiming for opportunities with a much shorter earn-back period?

So John, I'll start with a broader perspective. Strategically, Key is in a strong position. We have an appealing strategy and a growth path in our core businesses that is now enhanced by First Niagara. We are still in the process of realizing the value of First Niagara and delivering that value to our shareholders. I want to clarify that we are not pursuing acquisitions as part of our strategy, and if I suggested otherwise, that was not my intention. Regarding value creation, we have explored numerous aspects of First Niagara, and we genuinely believe that Key is uniquely positioned to unlock its potential. This is evident in our returns on tangible common equity, our efficiency ratio, and achieving expense savings of around 45% of the acquired cost base. I will let Don elaborate on our progress regarding the earn-back on tangible book value and how he views that. To conclude, John, I apologize if my previous comments led you to any unintended conclusions.

And as far as Beth's comments, I would just repeat that we've been very pleased with the financial results we've been able to achieve with First Niagara, that we're showing strong improvement in the categories that we knew that were important for us to achieve. We knew at the time of the announcement that the tangible book value dilution and payback period would be a challenge. I would say that we are seeing a quicker payback than what we originally had expected, and that's coming from the strength of the actual results and the performance we've seen to date. If you look at the tangible book value dilution that we have incurred to date, I would say over the next 3-plus years is when we go back to the point that we were at before the acquisition. And so I think that we're well positioned to have a much quicker payback period than what we initially thought.

And John, one last comment was, and in terms of stock price appreciation, our stock is up some 70% versus the index, the bank index for that period, the same period of time up 46%. So the forward value and the value realization, we do believe that was a good use of capital for our shareholders.

Yes. My first question is regarding GAAP NIM. Don, I appreciate your comments on the core NIM and its expected progression. Could you confirm the starting point for GAAP NIM in the third quarter? When we exclude the purchase accounting refinement, are we starting at around 3.15%, assuming everything else remains equal, according to the purchase accounting guidance you mentioned in your prepared remarks?

I calculated 3.16% because it was 14 basis points on the purchase accounting true-up for finalization.

Got it. And the second question is for Beth. Clearly, with a CET1 of almost 10%, you have a lot of capital for your risk profile and size, and you'll continue to build it over time. As we look forward to 2018, what would you tell your long-term shareholders about your range in terms of medium-term payout? How do you think about dividends versus buybacks in a period where the CCAR isn't becoming more challenging?

Thanks, Erika. Well, as we've talked about it, we have said that one of the things that we think is important, as the CCAR guidelines have been clarified, is the ability to lean into the dividend payout. We believe we hear that from our owners that the level of dividend payout is an important consideration in their investment thesis. So we have talked about a 40% to 50% targeted dividend payout over time. You saw us this year, in the construct of our Capital Plan, for a 2-tiered increase on our dividend payout through the second quarter of 2018. So that is an important part of how we approach CCAR. And then as we balance in any given year what the Capital Plan will look like in terms of return of capital to shareholders, we look at a number of things that, yes, it is indeed true that this is the first year where soft limits around 100% payout were not applicable, and we would always look at what we would do over and above dividends carefully in terms of what we think is the best use of our capital, both in terms of investing in the business as well as returning to shareholders.

I appreciate the comment on mix. Given that we observed your peers declare a total payout of 100% or more for this year's CCAR, I'm curious if, after the First Niagara deal, shareholders can expect a total payout of 100% or more, with the dividend being between 40% to 50%.

Erika, this is Don. And as far as our CET1, that we are at 9.5% after the acquisition, and we feel very comfortable with that level of capital. We do believe that we have to have something north of 9% to continue to meet the stress test associated with CCAR. And so while it could be higher over a short window, we think that to maintain our capital ratios would imply something maybe about an 80% payout ratio. And that's something that we'll have to tweak positively or negatively based on what we see for organic growth and other capital needs.

Don, I was hoping you could just expand a bit on your comments on the deposit mix shift in 2Q. I mean, some of the reasoning is pretty obvious with rates moving, but it sounds like there might also be just some other moving parts in the total portfolio. Yes, I think you had mentioned some either intentional or expected runoff. So just hoping you could maybe expand a little on sort of what's going well versus any way you might have been surprised. And then, I guess, more specifically, you indicated the negative mix shift probably would not continue. Just more background on why that would be the case.

Where we've been pleased is essentially with our retail deposit growth and our core commercial deposit growth. Where we've seen some outflows is more in the non-transaction oriented deposits. And so for example, this past quarter, we saw a decline of about $1.2 billion in our collateralized deposits, which really don't provide any liquidity for us, and had an impact on the overall rates that we have for our deposit mix. I'd say in some of the individual categories, you're going to see a little bit more shift in some of the commercial categories, which are driving up some of the overall rates in some of the deposit categories. But generally, we, again, have been pleased with the retail and core commercial transaction accounts.

Okay, perfect. And then just one separate kind of ticky tack one on the higher tax rates expectation. I mean, I definitely get the higher marginal rate on higher earnings. But was there anything else that changed? I guess I'm just wondering, presumably there would've been a ramp expected in the previous guidance as well. So was there anything else that changed sort of quarter to quarter that drove the expectation higher?

Really, if you take a look at our guidance update, it's up pretax about $100 million. And that incremental earnings is taxed at a marginal rate of over 37%. And so that will have the effect of increasing our average tax rate by over 50 basis points. And so that really is the reason for the shift up in the tax rate.

Don, I just kind of want to put a finer point on the comments around commercial real estate. I know you guys were talking about sort of your risk tolerance around CRE, but are you actually seeing any actual deterioration in commercial real estate? Do you expect to see deterioration in commercial real estate or weaker market terms? Or is it really just sort of Key's own preference for limiting CRE growth?

It is very much the latter. And actually, we've seen credit quality trends improve in commercial real estate. And so that hasn't been an issue. Chris had mentioned earlier that a couple of years ago, we started to exit certain markets. And those markets continue to do very well. And so maybe we put the brakes on a little too fast as far as being conservative there, but we want to make sure that we're cautious and using the capital appropriately as far as putting it to work with our customers.

Got it. Okay, that helps. And then just on the expense side, whether it's for you or Beth. Once you achieve the $450 million of expense savings, right, and let's ignore any potential acquisitions you might or might not do, where do you go from there, right? How much room is there to actually take down sort of Key's core operating expenses versus just getting the efficiency improvement because of higher revenues?

Great. And our model for the last several years has been one of continuous improvement and allowing us to generate cost savings to help fund the investments we want to make back in the business. And we believe that still is available to us prospectively. And a number of the cost-saving efforts that we had teed up before the acquisition of First Niagara were delayed because we wanted to focus most of the resources on the integration of First Niagara. And so we do believe there are some things that we can do to help achieve further cost saves. And that's going to be important for us in the long haul, especially since we're not seeing a GDP growth provide us any tailwinds as far as the growth in our bottom line.

Don, can I ask you two questions on balance sheet mix? Just on the securities portfolio, it looked like it came down a little bit on average. Can you just talk about just that in relation to what was happening on the liability side? Are you investing further? Or are you just kind of taking a pause? And any changes to the kind of roll-on, roll-off yields?

As far as the overall portfolio, I mentioned before that the collateralized deposits were down. And that gave us some flexibility as far as managing our overall investment portfolio. It's a free liquidity at that point in time, and so that's something we'll continue to reassess. I would say that, that overall investment portfolio size is more reflective of the balance sheet management and liquidity constraints for the company as opposed to any other purpose. And then as far as the new purchases, they're coming on at about a 40 basis point kind of spread compared to the roll-off position. It's 30 to 40 basis points overall. So.

Okay. So still net positive. Second question, just on the right side. Just in terms of this year, you guys were kind of close to the line on Tier 1 capital. And it came to the stress in the CCAR. And you guys are at 80 basis points of RWAs in terms of the preferred after the redemption of the First Niagara. Perhaps, can you just talk through just your comfort with your buffer? And do you anticipate any further needs in terms of that mix of capital over time in terms of issuance?

We'll continue to look at it over time because preferred is still an important part of that Tier 1 capital component. I would say as far as our stress-test results, we still believe that there's room for improvement there, that we don't believe that the Fed scenarios give us appropriate credit for some of the cost savings that we've already been able to achieve and discounting out some of the merger-related charges. We also know that there's some data elements that we didn't have in some of our earliest filings that probably resulted in higher loss projections under their models as well. And so we think over time that those both will improve for us as well.

This is Kyle Peterson standing in for Steve today. I have a couple of questions. Regarding core NIM, I understand there are some factors at play. We experienced a rate hike in June, and while security yields or replacement yields have improved slightly, there are also some fluctuations with deposits. I'm curious if you have any insights on where you expect core NIM to be in the upcoming quarters, considering the June rate hike.

Yes, the expectation would be generally relatively stable, which reflects the benefit of the June rate increase, but also the impact of lower purchase accounting and some of the other mix shifts that you talked about. I think, also, it's important to note that our guidance for the full year shows an increase of almost $100 million as far as the net interest income. And that's reflective of the balance sheet growth that we're expecting and also the strength of the margin going forward.

So I guess, if it's with a little bit lower purchase accounting, then you get a little better on the core ex accretion. Is that the right way to think about it?

Correct.

And then just a quick question. I didn't catch it in the release, and my apologies there. What was the preferred dividend expense that you guys had this quarter?

$14 million this quarter, and that's what we see going forward. So I know it was noisy in the first quarter, but it's now down to a stable level going forward.

Just trying to get a sense on the net charge-off guidance for the year. Looking at the table in the presentation, you guys have been below 40 basis points, I think, for the entire period in the presentation. Just wondering if you see things changing in the second half of the year where you expect net charge-offs to increase.

Our charge-off outlook would be fairly consistent with what we experienced in the first half of the year. You can always see a blip here or there. But generally, we would expect it to be fairly consistent; but as we highlighted before our credit quality metrics in the second quarter all improved, with nonperforming being down 12%. Criticized and classified has also improved. So I think we're pretty well positioned going into the second half of the year.

As we review our portfolio and business mix, we remain confident that the credit environment is stable. We have not identified any emerging issues or concerns in our portfolios. Realistically, any changes to the averages you have observed regarding net charge-offs would likely be minimal and specific, but there is nothing indicating a broader trend or shift.

And just a topical item of late, but just in terms of retail exposure, both C&I and CRE, I don't know if you have that handy, if you can tell maybe what percent of the loan portfolio is retail CRE and retail C&I?

What we've talked about before was if you look at the direct exposure to retailers, plus the direct exposure to a regional mall combined, it's around $1 billion. And so it's a fairly small portion of the overall portfolio.

I was just wondering, can you just give an update in terms of new account growth, deposit growth in Upstate New York?

We have seen deposit growth in what we refer to as the new markets. We are performing better than our initial projections for deposit growth. Additionally, we are in a better position in terms of customer attrition than we anticipated. Interestingly, 70% of the attrition, which is lower than expected, comes from customers with only one product or service. Overall, we are optimistic about the trend.

Just a follow-up. The comments earlier about customers choosing capital markets versus holding the loans on the balance sheet, loans held for sale had a nice increase from first to second quarter. Would that be a good indicator for the second half of the year in terms of capital markets' CMBS-type business and fee income?

Peter, this reflects the momentum and activity on our platform. However, there is significant churn in that number. Some of those figures may cover multiple quarters, while others might not, so it's not a number you can perfectly project. Overall, we feel positive about our business. We expect a record year for our investment banking and debt placement fees. The quarterly distribution will be smoother this year compared to last. Last year was particularly challenging in the second quarter, which caused some volatility. Still, we are optimistic about our business overall. But when looking at that specific number, it’s important to note that it may not accurately indicate trends for the third quarter.

Hi, good morning. I apologize if this has already been discussed, but managing overlapping calls makes it hard to keep track of everything. First, regarding revenue synergies, could you share your thoughts on that? Are you seeing any impact so far, how significant is it reflected in the numbers, and what are your feelings about the $300 million goal you've previously mentioned?

Saul, we feel really good about the $300 million goal. You will recall, when you talked about it being in the numbers, all the modeling that we did around the acquisition, specifically the $300 million of revenue, incremental revenue, were not in any of the numbers and the guidance we had given anyone going back to the acquisition. Getting back to the $300 million, we feel good about it. As you think about things like residential mortgage, payments, indirect auto, commercial mortgage banking, private banking, which is interesting because First Niagara really was not in the private banking business. And our private banking business right now has a lot of momentum. And so we think that's another area. Some of these sales, as you know, have a long tail. Some of them are relatively short. We've had some success that's already closed, for example, in commercial mortgage. But getting back to your question, we feel good about the $300 million in revenue synergies.

Understood. When I referred to the numbers, I meant whether it is evident in the first-half results. Have you pulled anything from the $300 million so far?

Yes. Saul, in my comments, and we realize we had some overlapping with another call, we said very early days in terms of what's in current results. But lots of confidence about the pipeline, the fit and the value of the revenue synergies going forward.

That'd be less than $20 million for the second half of the year between tangible amortization and operating expenses.

I wanted to ask a different question kind of as a go-forward. As you've gone through the acquisition, the allowance-to-loan ratio has dropped to about 1%. When you think about CECL, so how will that one be affected by what you have in your purchase kind of portfolio? And then how do you think of that in the sense of building back that loan loss allowance ratio as you kind of go into the new accounting?

One, regarding the rebuilding of the reserve, typically, we would expect the allowance to increase. However, it remained flat this quarter due to the improved credit quality we observed across the portfolio. We previously mentioned a 12% reduction in nonperforming loans, and the criticism and classification improved as well. This led to a stable allowance. Concerning CECL, we are still in the early stages of modeling for it. Generally, we anticipate that the allowance will be higher under CECL compared to previous GAAP. However, the impact may vary among different loan types and categories. It is still too early to determine, but we expect to see some increases in reserves as we move towards 2021, when we must implement CECL.

And then, Beth, you've seen the return on tangible common equity move up towards the lower end of your 13% to 15% kind of guidance, which is in direct result from the acquisition. So I think that's really what the benefit of this acquisition was, is really pushing that to a whole new level. What is the next kind of round of improvements to get you from right at 13% maybe towards the middle to upper end of that range?

Well, Marty, I think it is a function of implementation of the strategy. You're right. We were beneficial to get a step-change in the level of our return on tangible common equity with the merger. And now from here, it is the improved operating performance, continued strong capital management. And we see a path and a plan to move through that 13% to 15% guidance in the next couple of years.

This is Rob from Matt's team. With regards to your I-banking and debt placement fees, another strong quarter this quarter. Does the strength so far this year make you any more constructive in your outlook for the back half of the year versus maybe where you were last quarter or at beginning of the year?

We believe it's important to evaluate the business on a trailing-12 basis. We are very optimistic about our performance. As mentioned earlier, 2017 is set to be another record year with growth expected. Additionally, we anticipate that the business will show smoother quarter-to-quarter results compared to last year. The pipelines look robust as we look ahead, and we are pleased with the positive discussions we are having with our clients. As always, we recognize that everything is influenced by market conditions, but overall, we feel quite optimistic.

Okay. And then just separately, on the $345 million of First Niagara loan marks, can you remind us how much will ultimately flow through net interest income versus flow through credit? And then on the outlook for purchase accounting accretion, following the $100 million you expect in the back half of this year, how should we think about the step-down in 2018 and 2019?

The accretion all goes through margin. And so what you'll see over time is building back some of the reserves to offset some of that. But you will see that flow-through through margin prospectively. So like when we talked about the $58 million for the current quarter, you would see that step down to $53 million, and then $48 million would be our outlook for the next couple of quarters. I would also expect you to look at about a 20% kind of reduction per year prospectively from there.

Beth, can you give us a 30,000 foot type of view? We saw earlier in this quarter, in the second quarter, the treasury come out with their so-called white paper on their views of how regulation should change for the banking industry. And when you look at what they recommended, what are one or two or the top ones that would benefit Key if the regulators were to change or act on some of their recommendations?

Thanks. I believe the white paper is a significant marker for us. Nine years after the crisis, our banking sector is indeed stronger and more resilient, equipped with high levels of capital and liquidity. It’s important to explore regulatory reviews that simplify risk complexity. Specifically, there are opportunities regarding what qualifies for liquidity coverage ratio requirements and the capital requirements linked to mortgage and small business lending. These adjustments could be advantageous for Key and the industry as a whole. While we await further developments, I remain optimistic about the items under consideration, as the industry is currently resilient and well-capitalized, presenting potential benefits.

Great. As a follow-up, Chris, you mentioned the strength of the investment banking business, especially in real estate. While it's market dependent, how much of your results can be attributed to favorable market conditions compared to gaining market share and increasing customer penetration? Additionally, regarding First Niagara, I know you've had some early successes. Does it account for 0.5% of that business, or how is it shaping up for First Niagara at this time?

So a couple of things. Before I get to First Niagara, clearly, we, Gerard, pay very close attention to where we stand from a market share perspective. And I can tell you, in our capital markets businesses, we are gaining share. And we use an outside service, the same folks that we've used for a long time. And so it is share gain in addition to the markets obviously being open and available. With respect to First Niagara, it's very early days. It would not equate to 0.5%. But what's interesting is we're having a lot of discussions with legacy First Niagara clients. So that's in the future. But in terms of actually having revenue in our investment banking and debt placement fee numbers, not yet a big number. As I mentioned earlier, we did use our commercial mortgage business to place about $200 million with Fannie and Freddie.

Again, we thank you for taking time from your schedule to participate in our call today. If you have any follow-up questions, you can direct them to our Investor Relations team at 216-689-4221. And that concludes our remarks. And again, thank you.