Keycorp (KEY) — Q4 2023 Earnings Call Transcript

Thank you for joining us for KeyCorp's fourth quarter 2023 earnings conference call. Joining me on the call today are Clark Khayat, our Chief Financial Officer; and our Chief Risk Officer, Darrin Benhart, who succeeded Mark Midkiff at the beginning of this year. 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. This morning, we reported earnings of $30 million or $0.03 per share. Our results included $209 million of after-tax expenses or $0.22 per share from three items that Clark will describe in more detail later. For the year, we reported EPS of $0.88 including $0.27 impact from similar types of expenses. Fourth quarter closes out a challenging year for the industry and for Key. While our business fundamentals remain solid throughout the year, we acknowledge that our balance sheet coming into the year was not well positioned for the rapid rise in interest rates that transpired. We took a number of necessary steps as we moved through the year to enhance our balance sheet liquidity and capital position, in preparation for potential changes in capital rules, positioning ourselves to be a simpler, smaller, more profitable bank. These actions also had some near-term financial impacts. As a result, we missed our own expectations and yours. However, as we turn the page to 2024, I think it is really important to step back and recognize that Key accomplished a number of positive things last year and as a result, I am confident we have laid the groundwork as we move forward. First and most importantly, throughout the year, the tremendous work and dedication of our teammates allowed us to continue to serve and support our clients through turbulent market conditions, particularly in the first half of the year. I am very thankful and proud of our teammates as they set aside the noise affecting our industry, stepped up and continued to focus on executing on our strategic priorities and steadfastly serving our clients. Our focus on relationships continues to guide our balance sheet optimization efforts. In 2023, we reduced loans by $7 billion as we deemphasized credit-only and other non-relationship business. Despite this meaningful reduction in lending, we grew the number of relationship clients and households we serve across both our consumer and commercial businesses and grew deposits by $3 billion. In consumer, we grew relationship households by 3%, with about two-thirds of new relationships coming from younger demographics. Relationship deposits grew by 1%. Commercial clients grew 4% and commercial balances grew 5% as a result of our continued focus on primacy. About 96% of our commercial deposits were from clients that had an operating account with Key as of December. As a result of our ability to raise relationship deposits while reducing loans, we were able to meaningfully reduce our reliance on wholesale funding as the year progressed. We also continued to raise significant capital for the benefit of our clients, over $80 billion in 2023, leveraging our unique distribution capabilities. This proven and mature underwrite-to-distribute model is a key differentiator for us. On expenses, we made significant headway in simplifying and streamlining our businesses. We exited certain capital-intensive and non-relationship businesses such as vendor finance, as we have previously done with Indirect auto. In November, we announced a number of organizational changes, including the reorganization and consolidation of our commercial banking and payments businesses. We also realigned our real estate capital business with those of our institutional bank. By aligning product-based teams to the client-facing businesses they serve, we are reducing overhead and complexity and creating a better client and prospect experience. Altogether, these actions we took in '23 impacted 6% of our teammates. Additionally, we continue to rationalize our non-branch, non-operation center real estate footprint, which has declined by 34% over the past three years. We do not take these decisions lightly, but the reality is, we need to make the difficult decisions today to earn the right to invest in the opportunities of tomorrow. Last year's actions freed up over $400 million on an annualized basis that we will redeploy to deliver value for our clients and drive future growth. More broadly, these actions combined with our ongoing disciplined expense management have enabled us to hold core expenses essentially flat at $4.4 billion annually over the past two years, and that is in spite of inflationary headwinds facing our industry. On the capital front, our risk-weighted assets decreased by $14 billion from the beginning of the year, exceeding our full year optimization goal of $10 billion. Concurrently, we also increased our common equity Tier 1 numerator through net capital generation. As a result, our CET1 ratio increased by 90 basis points to 10% at year-end, well above our targeted capital range of 9% to 9.5%. Our capital metrics, including AOCI also improved as lower interest rates and the continued pull to par over time of the unrealized losses in our investment portfolio drove over $1 billion of improvement in our AOCI over the past year. Tangible book value and tangible common equity ratios both improved meaningfully. Overall, our capital position remains strong. We are well positioned relative to our capital priorities and the currently proposed future capital requirements. In fact, we think we're advantaged relative to other category four banks, given our underwrite-to-distribute model and the asset-light businesses that we have, including a scaled wealth business with $55 billion of assets under management. Also, I want to comment on credit quality, which I believe is the most important determinant of return on tangible common equity and shareholder value over time. Credit quality remains a clear strength of Key. Our credit measures reflect the derisking we have done over the past decade and our distinctive underwrite-to-distribute model. Net charge offs were 26 basis points in the fourth quarter and 21 basis points for the full year. Our NPAs, which we firmly believe have very low loss content, remain well below our historical averages. The quality of our loan portfolio continues to serve us well, with over half of our C&I loans rated as investment grade or the equivalent. Our consumer clients have a weighted average FICO score of approximately 768 at origination. As a reminder, we have limited exposure to leverage lending, office loans and other high-risk categories. Two-thirds of our commercial real estate exposure is multifamily, of which approximately 40% is in affordable housing, which continues to be a significant and unmet need in this country. As we move to 2024, I want to provide my key takeaways from the guidance that Clark will walk you through in more detail shortly. First, we have a clearly defined net interest income opportunity moving forward as our short-term swaps and treasuries reprice, particularly in the second half of the year. Importantly, we believe this can be achieved across a range of interest rate scenarios as a result of the significant work the team has done over the past year to improve our balance sheet resiliency. We began to see some of that work payoff this quarter as our net interest income grew slightly relative to the third quarter. Our momentum makes me confident that we saw our net interest margin bottom out in the third quarter of 2023. Secondly, we have leading positions and meaningful growth opportunities across capital markets, payments, and wealth management. We have consistently invested through the cycle in these differentiated fee businesses where we have targeted scale. We continue to see good client engagement and our pipelines remain strong. Any normalization in the capital markets represents an upside opportunity for Key, not only for fees but from the balance sheet management perspective that I spoke about earlier. Thirdly, while the macroeconomic outlook remains highly uncertain, based on our current assumptions, we anticipate we will generate moderate positive operating leverage for the full year 2024. Finally, we continue to expect that we will outperform the industry this cycle with respect to credit. Credit quality remains one of our most significant strengths. Over the next several quarters, we continue to expect to operate below our through-the-cycle net charge-off range of 40 to 60 basis points. In summary, we acknowledge 2023 was a challenging year. Difficult, but necessary decisions were made and actions were taken. But at this point, we are nearly finished with that process. Our balance sheet is now appropriately sized for the environment in which we are operating. We are better positioned for changes in interest rates up or down. Our demonstrated ability to manage and grow our deposits proves to be a strong foundation. We are now in a position where we can be more opportunistic as we turn the page to 2024. Before I turn it over to Clark, I want to take a moment to acknowledge last week, we announced Vernon Patterson's retirement from Key. As Head of IR, Vernon has led Key through 112 earnings releases and countless meetings with investors and other stakeholders. I am so grateful, Vernon, to have worked alongside you. I have tremendous appreciation for the great relationships you have throughout our industry and within our company.

Thanks, Chris. I would echo your comments on Vern and a warm welcome to Brian as well. I am now on Slide 5. For the fourth quarter, net income from continuing operations was $0.03 per common share, down $0.26 from the prior quarter and down $0.35 from last year. Our results this quarter were impacted by three items totaling $0.22 per share: first, $190 million from an FDIC special assessment; second, $67 million from an efficiency-related expense; and third, $18 million from a pension settlement charge, for a total of $275 million pre-tax or $209 million after tax. A breakdown of these items can be found on the last page of our slide presentation. Our fourth quarter results were generally consistent with the guidance we provided last month. As expected, we saw stability in the non-interest income line this quarter, and our net interest margin increased by 6 basis points relative to the third quarter as we began to see some early benefits from our swap and treasury portfolios. Fees declined 5% sequentially on the better end of the range we provided last month. Expense growth was primarily attributable to the three items I mentioned. Without these items, expenses would have been relatively stable compared to the third quarter. Net charge-offs as a percent of loans remained low at 26 basis points, and we added $26 million to our allowance for credit losses to reflect some modest migration of the portfolio, primarily in real estate and the still uncertain macro outlook. Additionally, as Chris highlighted in his remarks, our results reflect our focus on primacy and building relationships, our improved capital position and our strong risk discipline. Turning to Slide 6, average loans for the quarter were $114 billion, down 3% from both the year-ago period and prior quarter. The decline in average loans was primarily driven by a reduction in C&I balances, which were down 4% from the prior quarter. The reduction reflects our planned balance sheet optimization efforts, which prioritize full relationships and deemphasize credit-only and non-relationship business. We reduced risk-weighted assets by $4 billion in the fourth quarter and, as Chris mentioned, by approximately $14 billion in 2023. The majority of the decline in risk-weighted assets this quarter was from lower loan balances, with some reduction in unused commitments also contributing. We would expect modest RWA reductions in the first half of 2024. Turning to Slide 7, Key's long-standing commitment to primacy continues to deliver a stable, diverse base of core deposits for funding. Despite a year of market volatility, we grew period-end deposits year-over-year by $3 billion, and average deposits were relatively stable compared to the year-ago period and prior quarter. On a sequential basis, commercial deposits grew 4%, which we attribute primarily to seasonal build, and consumer deposits grew 1%. The increase in commercial and consumer deposits was mostly offset by a $2 billion decline in broker deposits on average as we continue to improve the quality of our funding mix by growing core relationship balances and reducing reliance on wholesale funding and broker deposits. Since the end of the first quarter, we generated almost $13 billion of liquidity by reducing loans and growing relationship deposits and reduced wholesale borrowings by $12 billion. Our total cost of deposits was 206 basis points in the fourth quarter, and our cumulative deposit beta, which includes all interest-bearing deposits, was 49% since the Fed began raising interest rates, in line with our prior guidance of approaching 50% by year-end 2023. The higher rate environment continued to impact our deposit mix as our noninterest-bearing deposits declined by 1% sequentially to 22%. Pressure on deposit pricing appears to be abating across the franchise, and we expect some mix shift to continue as long as rates remain high. Turning to Slide 8, taxable equivalent net interest income was $928 million for the fourth quarter, down 24% from the year-ago period and up slightly from the prior quarter. Our net interest margin was 2.07% for the fourth quarter compared to 2.73% for the same period last year and 2.01% for the fourth quarter of the prior quarter. Year-over-year net interest income and net interest margin reflect the impact of higher interest rates as increased costs of interest-bearing deposits and borrowings outpaced the benefit from higher year-earning asset yields. Additionally, the balance sheet experienced a shift in funding mix from noninterest-bearing deposits to higher-cost interest-bearing deposits. Relative to the third quarter, the increase in net interest income and net interest margin was driven by actions taken to manage key interest rate risk, elevated levels of liquidity, and improved funding mix. The increase was partly offset by higher interest-bearing deposit costs, which exceeded the benefit from higher earning asset yields. While the planned reduction in loan balances adversely impacted net interest income sequentially, it benefited Key's net interest margin. Our net interest margin and net interest income continue to reflect the headwind from our short-dated treasuries and swaps, which together reduced net interest income by $345 million this quarter or by $1.4 billion for the full year and lowered our net interest margin by 77 basis points this quarter. As previously discussed during our third quarter earnings call, in October, we terminated $7.5 billion of received fixed cash flow swaps, which were scheduled to mature throughout 2024. Last quarter, we said that net interest margin would bottom, and it did. Throughout 2024, we would expect continued benefit from the maturities of our short-term swaps and treasuries, especially as more mature in the back half of the year. Moving to Slide 9, non-interest income was $610 million for the fourth quarter of 2023, down $61 million from the year-ago period and down $33 million from the third quarter. The decrease in non-interest income from a year ago reflects a $36 million decline in investment banking and debt placement fees, driven by lower syndication fees and M&A advisory. Additionally, corporate services income declined $22 million driven by lower customer derivatives trading revenue. The decrease in non-interest income from the third quarter reflects a $13 million decrease in other income, primarily driven by a gain on a loan sale in the prior quarter. I'm now on Slide 10. Total non-interest expense for the quarter was $1.4 billion, up $216 million from the year-ago period and up $262 million from last quarter. As mentioned, fourth quarter results reflect $275 million of impact from FDIC assessment, efficiency-related expenses, and pension settlement charges. Efficiency-related expenses included $39 million related to severance and $24 million of corporate real estate rationalization and other contract termination or renegotiation costs. Excluding these items, expenses were relatively stable in the quarter and down compared to the year-ago period. We continue to proactively manage our expense base and simplify and streamline our business so we can continue to reinvest in all our businesses. Moving to Slide 11. Overall credit quality and our related outlook remain solid. For the fourth quarter, net charge-offs were $76 million or 26 basis points of average loans. This compares to $71 million in the prior quarter. Criticized outstanding to period-end loans increased 50 basis points this quarter driven by movements in real estate, healthcare, and consumer goods. While nonperforming loans and criticized loans continue to move up off their historical lows, we believe Key is well positioned in terms of potential loss content. Over half of our NPLs are still current. Our provision for credit losses was $102 million for the fourth quarter, including $26 million of reserve build, and our allowance for credit losses to period-end loans increased from 1.54% to 1.60%. Turning to Slide 12, we significantly increased our capital position throughout 2023. We ended the fourth quarter with a common equity Tier 1 ratio of 10%, up 20 basis points from the prior quarter and up 90 basis points from the year-ago period. We remain focused on building capital in advance of newly proposed capital rules, while continuing to support relationship client activity and the return of capital. As such, we expect to stay above our current targeted range of 9% to 9.5% and do not expect to be buying back our stock in the near-term. Our AOCI position improved by $1.4 billion this quarter. The right side of this slide shows Key's go-forward expected reduction in our AOCI mark based on two scenarios. The forward curve is December 31st, which assumes six FOMC rate cuts in 2024 and another scenario where rates remain at their current levels. In the forward curve scenario, the AOCI mark is expected to decline by approximately 24% by the end of 2024 and 34% by the end of 2025, which would provide approximately $1.8 billion of capital build through that time frame. In the flat rate scenario, we still achieved 90% of that benefit between now and year-end 2025. Said differently, we still accrete $1.6 billion of capital should rates remain flat to current levels, driven by maturities, cash flow, and time. Slide 13 provides our outlook for 2024 relative to 2023. Given uncertainty regarding the eventual timing and extent of Fed interest rate cuts in 2024, our guidance reflects outputs from a few potential scenarios ranging from the December 31st forward curve, which assumes 625 basis point cuts over the course of 2024, starting with an initial cut in March to a scenario more closely aligned with the Fed's dot plots, which currently assumes three rate cuts. We expect average loans to be down 5% to 7%, mostly reflecting the actions we have already taken over the course of 2023. In other words, the vast majority of the decline in average loans is a function of our reductions in 2023 and are reflected in our year-end balance. We expect period-end loans at the end of 2024 to be relatively stable compared to the end of 2023, with some decline in the first half of the year offset by growth expected in the second half of 2024. We expect average deposits to be flat to down 2%. Net interest income is expected to be down 2% to 5%, mostly reflecting the lower fourth quarter exit rate relative for the first half of 2023. This equates to net interest income in 2024 that is up low-single-digits relative to our annualized fourth quarter exit rate. I'll provide more color on our net interest income outlook shortly. We expect non-interest income to be up 5% or better with upside if capital market activity normalizes and market levels and GDP trends remain constructive. Non-interest expense should be relatively stable at about $4.4 billion as we realize the benefits from our 2023 efficiency actions. We will continue to tightly manage our cost base, including executing on additional opportunities to simplify and streamline our organization. At the same time, we will continue to protect and invest in our franchise, including most importantly our people. As Chris mentioned, our guidance suggests moderate positive operating leverage in 2024, driven by meaningful expansion in the second half of the year outpacing tough comparisons in the first half. For the year, we expect credit quality to remain strong and net charge-offs to continue to modestly increase to the 30 to 40 basis point range, still well below our over-the-cycle range of 40 to 60 basis points. Our guidance for our GAAP tax rate is approximately 20%. Turning to Slide 14. Given heightened investor focus on this topic, we wanted to provide a little more granularity than we have in the past about the pacing of our net interest income opportunity as we move through 2024. Hopefully, by now you're familiar with our well-defined net interest income tailwind as the impact of our short-term swaps roll off and treasuries mature, especially in the back half of 2024. The ultimate opportunity remains largely unchanged at approximately $900 million. As a reminder, the benefit increases each quarter as more of the swaps roll off and treasuries mature, culminating in the full amount in the first quarter of 2025. So, this all builds quarter by quarter since the initial set of swaps came off the books in the first quarter of 2023. As you turn the page on 2023, we are nearing the halfway point of this journey. Since we're now through three full quarters, we're sharing a three-part view. First, on the left in light gray are the three quarters of benefit we've already realized. In total for 2023, that was approximately $85 million of additional income. The next four bars show the progression through 2024. As you see, the value builds from each quarter's tranche and accrues in the following quarter. Each bar represents the value for the quarter. In other words, in 1Q '24, we expect to realize $78 million of additional net interest versus 1Q '23 from these positions. For 2024, we estimate the benefit to ultimately $500 million in total, which is the sum of the four quarterly bars. This would represent an increase of more than $400 million over the benefit received in 2023, which, as previously mentioned, was approximately $85 million. The final bar to the far right, which has been the main focus of this discussion over the last year or so, is the first quarter 2025 number. This shows the benefit currently estimated for the quarter at approximately $220 million for essentially the entire swap and short-term treasury portfolios rolling off. Again, this is incremental to 1Q '23 and represents an annualized value of approximately $900 million. We believe the reinvestment of these fixed-rate assets and swaps represents an outsized opportunity for Key relative to our peers, but it's also important to remember that this is just one component that drives our net interest income outlook. On Slide 15, we provide other key inputs and assumptions driving our NII outlook, deposit betas, balances and mix, loan growth as well as seasonal factors. Putting this all together, we expect our first quarter NII to be down 3% to 5% from the fourth quarter. From there, we expect to grow and start to accelerate in the second half of the year as the pace of swaps and U.S. Treasury maturities pick up meaningfully at nearly $5 billion in aggregate per quarter. From the fourth quarter of 2023 to the fourth quarter of 2024, we expect our quarterly net interest income to grow 10% plus and exit the year north of $1 billion. We would also expect the net interest margin to improve meaningfully to the 2.40% to 2.50% range by the end of 2024. This will put us on a strong trajectory as we enter 2025. With that, I will now turn the call back to the operator for instructions for the Q&A portion of our call.

Clark, a lot of good color on the net interest income with those slides. But can you just go into a little bit more detail about the moving parts to the net interest income opportunity and maybe some other factors that impacts your outlook? And then secondly, if you could talk about the quarterly NII progression, you gave us the first quarter down 3%, but clearly, it's going to be a pretty meaningful uptick in the second half of the year?

Sure. Thanks, Peter, and appreciate the question. I know this is a point of interest. So let me provide a little bit of context to the guide and the trajectory and hopefully, it will be helpful. I think first maybe just start with the puts and takes, which I think is the nature of your question there. And I'm going to just categorize sort of the big movers. I think, one, loan balances, which again we guided kind of down 5% to 7% for the year. Asset yields, I'm going to separate those from the swaps and treasuries, because I just want to identify those separately. Deposit balances, deposit pricing, and funding costs, and then the swaps and treasury portfolio. So, if you think about those as kind of five key levers on the guide. If I go full-year '23 to full-year '24, which we've said down 2% to 5%. The headwinds there are going to be the loan book, so down 5% to 7%. Obviously, that's going to impact NII, deposits flat to down is a little bit of drag. Earning asset yields will drop year-over-year as rates get cut. And then deposit and funding costs will be up for the year as that fourth quarter kind of annualized number rolls through. So those are the headwinds. What we have coming our way is the swaps in the treasury portfolio as they mature throughout the year. And then a better funding mix as we move through and become more and more reliant on deposits as we have this year. So that sort of dimensionalizes what that year-over-year look shakes out to be.

And just what are you expecting or assuming in terms of the forward curve and the timing of the rate cuts?

So our guide of 2% to 5% kind of incorporates a couple of different views, kind of the range being the current forward down 6% with the first cut in March, incorporating the lesser cuts on the three Fed dot plots. I think our general view is more aligned to four cuts with the first one in the middle of the year. But we're trying to provide guidance that I think incorporates all that. And as you know, when those cuts occur and the magnitude of that will roll through to how we manage our deposit pricing obviously.

And then, Vern, congratulations on the announcement. It's just been a pure pleasure working with you, and the investment community will be missing you.

Thank you, Peter.

Thanks for all the moving pieces in the NII color. I guess, Clark, you've discussed the 3% sort of normalized margin, I know we get sort of one final uplift between fourth quarter of next year and first part of 2025. So, I think the way you've guided to the fourth quarter of next year gets you a lot of the way there, but certainly still some room left over. Is the 3% normalized margin kind of still where you're bogeying and what has to happen to get us to that sort of range?

Yes. Thanks, Scott. So, if you just go back, and we've talked a little bit about this, and it's overly simplistic to be clear. But if we took second, third, and fourth quarter of '23 and put the impact of swaps and treasuries back in the margin, we'd be 281 to 284 in those quarters, which we think is pretty reflective of what we've got right now and that's with this sort of oddly longstanding downward sloping yield curve. So, I think that range as we get into '25 feels like achievable, and I think getting to that longer-term three probably needs us to have a more traditional upward-sloping yield curve just that tends to accrue a little bit to all of our benefit on NIM. But I do think that 280 plus is pretty reflective of the underlying core ability of the business as it stands today.

And then either Clark or Chris, just the fee guidance, feels like you're approaching it with an abundance of conservatism regarding the capital markets outlook. Just curious if you could maybe put a finer point on what sort of recovery you are presuming and what kind of upward leverage there might be if things do normalize?

Sure, Scott. Happy to address that. So if you take what we just reported of $136 million specifically on the line you asked about investment banking and debt placement fees, that would annualize at about $5.44 billion. Conversely, if you took sort of the business and removed 2021 and said that's an outlier, the traditional run rate is at least kind of $650 million. So, I think we have been conservative, and that's why we, when we gave guidance, we said non-interest income up 5 plus, and then we put the qualifier upside of capital markets activity normalizes. We don't see it really normalizing until the back half of the year. However, it's an interesting phenomenon when the 10-year went above 5% and then came back down. As you can imagine, people started to transact. And so, we're seeing the beginning of it now, but yes, it's a conservative number. The other thing that's in that fee number is, you saw that we had a step down with respect to our derivatives and hedging income. A lot of that is tied to the balance sheet, and as we go through 2024 and we get back to growing the balance sheet after going through our exercise on RWAs, you'll see that come back as well.

First, congratulations, Vern. Best of luck. You're a legend. And Brian, welcome. Looking forward to working with you again. Question on the, a little bit more on the NII dynamics. Wanted to get your thoughts on, if we do see the cuts materialize as you've baked in your expectations, what type of deposit beta you expect is achievable on the initial cuts? And how would you think about accumulative on the way down? And what is factored into your net interest income outlook in terms of that beta?

So I'll start with that, and then I'm going to flip it over to Clark. A couple of things to keep in mind. We have a big commercial franchise. And so 40% of our deposits, $145 billion, are commercial, and of those about two-thirds are either indexed or index-like. Now on the other side of the equation, we've been pretty conservative in assuming that as the first cuts, particularly if they aren't steep cuts, that we'll continue to get drift up on the consumer side. Also, we’ve forecasted just a bit of continued transition from interest-bearing to noninterest-bearing, but we think we've sort of bottomed out there. Clark, what would you add to that?

Yes. So maybe broadly, John, on the NII guide, we would expect some drift up, particularly in the first quarter on deposit pricing just as rates stay high. As Chris said, when the cuts come, I think a good way to think about that commercial book, as we've talked about the index nature of it, as Chris just referenced, is sort of kind of an almost automatic mid-teens beta on a cut, because of how that index pulls through. So the question really is going to be what happens to the consumer book and how quickly can we move that. I think a 25 basis point cut with a kind of long waiting period. Does it provide a lot of opportunity to reduce? If we start to see bigger cuts or cuts sooner or more rapid cuts that allow us to deploy those price reductions into the book.

Got it. Okay. And then separately, on the credit front, can you give us a little bit more color on the 25% increase in nonperformers in the quarter? And maybe a little more color on the criticized asset increase? And I know your commercial real estate NPL ratio now is 6.9%. What was that last quarter? Was that the biggest increase in the nonperformers?

Yes, I'll come back to you on the increase from the third quarter. I don't have that right in front of me. But on your other points, the NPA uptick really is a small list of identified credits, most of which we feel very good about the loss content. So it is a pickup in the ratio, but we don't think that's a loss driver. On criticized, look, that is a function of continued higher rates, putting some stress on what I'd call kind of the first order variable around debt service coverage.

And just one clarification, so it was primarily C&I related in terms of the NPA increase or CRE?

There were three specific credits, one of which was real estate.

I wanted to extend my best to Vern as well. And I just wanted to say we really appreciate all your help over there. So a big thank you. And then on my question, I think you said you still expect some modest RWA reduction in the first half of 2024. Is that all coming from the loan book? And as we think about the long end of the curve staying here or even moving lower, you should have a lot more clarity on accreting that AOCI back over time. So, what would you need to start leaning into loan growth a little or deploying capital elsewhere?

Sure. So, we are about where we need to be in terms of going through our whole portfolio. As we went through and we're looking and focused on RWAs, really it was sort of in three buckets, and we actually went account by account. And I've often said that on a risk-adjusted basis, stand-alone credit properly graded can't return its cost of capital. And so we were extremely prescriptive across the entire firm of going through that. On top of that, we exited some businesses like vendor finance that, by the way, is a credit-only business. And then on top of that, there were certain areas where we were conservative in terms of our capital treatment, where we could actually reduce RWAs without, in fact, having any impact on NII. That process is really over. When I say the process is over, we will continue, obviously, to look through our portfolio. But in terms of really seeing the step down in RWAs, as you saw last year, $14 billion, that's behind us. And so as we look forward, Clark talked about sort of the lag from the starting point on loan growth. But as you know, we have the ability to generate loan growth here at Key. We've got a long history of that. We'll be back kind of focused on serving our clients. Now having said that, I personally have a view; everyone is sort of coalesced around the soft landing. I think inflation is still pretty sticky. I think there are a bunch of drivers out there. We're managing the business for a short recession in 2024. And obviously, that goes into our thinking because if you think about working capital in the context of a shrinking economy, that shrink some loan demand. The other thing that we have to grow through, and this is by design, is we're going to have $3 billion of runoff in our consumer business. I hope that helps kind of on the puts and takes. When there's business to be done from a loan perspective, I'm confident that we can get it.

The only other thing I'd add, Manan, is just to reground everybody in the average-to-average move. So $118 billion of average in '23, ending point $112.6. So most of that decline in loans happened last year. We're pulling that through. There may be a little bit more, as we said, in the first quarter, maybe into the second quarter, as some of that non-relationship business continues to move out. But we'll see the build back through the course of the year and expect the ending of '24 to be relatively stable with where we exit '23. So we'll see a rebound. And to Chris's point, if there's less softness in the economy and more opportunity, then we'll lean into that opportunity.

That's very helpful. And then for my follow-up, as we look out into 2025, there's a lot of puts and takes here on the NII side. But what's the most optimal rate environment for Key? Is it six rate cuts and then an upward sloping yield curve? Is that the most optimal environment? Or would you rather see a higher short-end rate and a flatter yield curve?

I believe that an upward sloping yield curve generally benefits the business. I'm not overly focused on whether there will be four or six rate cuts as we progress through the year. Although we are currently sensitive to liabilities, as the year goes on and our swaps and treasury portfolios reduce, we will naturally become slightly more sensitive to assets. Therefore, we aim to be neutral and effective in any of those conditions. Overall, given a choice, I think being in an upward sloping yield curve is always advantageous for our business.

I apologize for one more question on net interest income. I think the stock is a bit weak today because the consensus expected a positive quarterly progression on the net interest margin due to the fixed rate opportunity. I'm curious about how the modest RWA reductions you are forecasting for the first half of the year impact the NII trajectory. Are those RWAs being reduced through credit-linked notes that could affect the net interest income? Additionally, looking beyond the first half of the year, do you believe we've reached a point where the process, as Chris mentioned, is complete? Is it fair to think of your balance sheet in a cleaner way relative to where you believe capital could be in the second half of the year? In other words, will there be no further wholesale actions that could influence this NII and NIM trajectory?

Thank you, Erika, for the good question. The decline in the first half is a result of actions we took last year to manage risk-weighted assets. We're seeing a decrease in both relationship and credit-only clients. Currently, we are not considering any impact from risk-weighted asset management related to credit-linked notes, though we are exploring those opportunities. Right now, our focus is on loan reduction, which may create some pressure in the first quarter, along with persistently high rates that could affect outcomes under various scenarios and lead to slight beta drift. However, I agree that having a clean balance sheet as we enter the second half is an important consideration. And I think, again, we're suggesting kind of a tepid recession kind of mid to late year, and if that doesn't come through and we see a more constructive economic environment, I think there's some opportunity to grow loans. But I do think as we progress through the year, you'll see NIM expand, you'll see NII grow nicely, and you'll see the balance sheet, I think, on the right trajectory.

Got it. And my second question is a bit of a two-parter as I'm trying to squeeze it in. One, Clark, I think when I first met you, I was very impressed by how you were so good at understanding where your funding needs and funding sources. So my question for you is, are these two-thirds of your commercial deposits in commercial, are they truly indexed on the way down, right? There's a few regional banks that have warned us that they're indexed on the way up and perhaps more negotiated on the way down. And I guess the other question is that, is it possible to break down on Slide 14 on your maturity schedule, what would the treasury's component be and the swap component, only because, obviously, there's a lot of debate on whether or not the cuts in the curve will happen, which clearly impacts some of the math behind the swaps?

Yes, the second question is straightforward. We have provided that breakdown before and will do so again. Regarding the first question, it's a valid point since not all commercial deposits are contractually indexed. It can be easy to negotiate with clients when offering them a rate, but it's more challenging when we need to take it away. However, we believe that while the impact may not be perfect, we have invested significant time with these clients. We have engaged with them extensively over the past year and have gained a solid understanding of these dynamics. We anticipate that the indexed component will come through as expected.

Got it. And Vern.

Thanks, Erika.

Just a quick clarification. The fee guidance of 5%, you walked through a lot of detail on that on banking. Does that assume the 4Q annualized level, the kind of up $100 million more normal level or somewhere between?

It's a little bit in between, Matt, probably a little more leaning toward the higher number, but we do think if markets kind of fully normalized, we'd see a little bit outside. So, it’s better than the annualized fourth quarter, not quite all the way to what we would think is normal operation.

Chris, one interesting development over the last 12 to 36 months has been the increased competition from private credit lenders in the commercial space. Can you share what you are observing from competition with those non-depository lenders, considering you are a strong regional lender in the C&I space? Additionally, if any of them are your customers, how do you manage their needs while also competing with them for lending?

Sure. It's a great question, and it's developing quickly. So principally, they are customers of ours, and let me explain what I mean by that. As you well know, we distribute 80% of the capital we raised. So we are distributing, all the time, a lot of paper to these private debt funds, and it's an important part of our underwrite-to-distribute model. As we've said many times, for banks, a stand-alone properly graded credit can't return its cost of capital. That is not the situation for the private debt funds. They have the benefit of leverage on leverage. We have to be a relationship bank. We have to be able to provide all of the payments capabilities, all of the capital markets capabilities. And that's actually an opportunity for us, because I think what you'll see is as these private debt funds continue to grow, they'll need to partner with banks and they'll want to partner with banks that have sophisticated capabilities around things like payments and capital markets, but don't necessarily want to hold on a risk-adjusted basis, paper that doesn't return, it doesn't hurdle. So, I look at it, frankly, as an opportunity for us. I think we're well positioned for that.

Very good. And then coming back to credit, you mentioned, obviously, you have minimal or very low exposure to office space, which is great in this environment. And then you have the multifamily exposure, but 40%, I think you said was in low-cost housing. Can you share with us what are you guys seeing in some of the markets where there's been a rapid build-up of not necessarily low-cost housing or subsidized housing, but normal housing in the multifamily? Are you seeing issues in that sub-segment of the multifamily market? Or do you not have much exposure to those markets that are growing rapidly?

We have limited exposure because we exited many of these gateway cities about five years ago due to affordability and cap rates. However, we have significant insight as we manage over $200 billion in loans through our third-party commercial loan servicing business. Currently, 44% of loans in active special servicing, which refers to those in workout, are in the office sector. The fastest-growing segment over the last quarter is actually multifamily in some of these gateway cities. While this is not a focus area for us, we are able to gather information through our loan servicing operations. Additionally, it's worth noting that the volume in special servicing has decreased; we had a record year in 2023, and the active special servicing figures actually went down, which is a noteworthy trend for those monitoring the market.

Well, Chris, one of your competitors' CEOs said scale has never been more important, and that competitor is larger than you are. And so pulling back the lens, how do you think about scale and how it's changed in the past year? And I have two specific questions before you give that broader answer. What percent of the value of commercial relationships is from the deposits? That's a specific number. And then what percent of the revenues that you get from your typical commercial relationship is fee-based versus lending-based, because I think that gets to the larger value proposition of Key?

Absolutely. Let me address the broader question first, then we can discuss the breakdown of spread income versus fee income. I believe that's an effective measure. Throughout Key, our fee income is at 40%, which is among the highest for a Category 4 bank. In our institutional bank, some sectors have a ratio of 80% fees to 20% spread. This varies across different businesses due to varying capital intensity. We closely monitor this metric to assess our market penetration. Regarding scale, it's an important consideration. With higher capital costs, achieving scale becomes more valuable than it was a year ago, and this applies to factors like cybersecurity as well. So, in that sense, scale is likely to be more crucial today than it was a year ago. I believe that scale is not the solution for a bank like Key. The reason is that when faced with competitors 20 times larger, we must reconsider what scale truly means. Instead, we have chosen to focus on targeted scale to ensure we remain highly relevant to our customers. We are not aiming to compete in the same way as the largest banks; they have a successful business model, but that is not the approach we are pursuing.

I want to start by congratulating you, Vern. You're truly one of a kind, and we will miss you. Now, I want to revisit Clark's earlier response to Scott Siefers regarding where NIM could go. You mentioned it could be between 2.80 and 3 in a more normal environment, whatever that means, since we haven't seen it in 20 years. Previously, you used to achieve 3 to 3.20. My question has two parts. First, is there something structural, possibly related to how you're currently using swaps, that sets a lower ceiling for them? Is 3 the upper limit now? Secondly, if that benefit continues into 2024 and potentially improves in 2025, how do you see NIM expanding by 2025? If we assume a more typical curve, will that be the moment to increase your investment pace after a long period of cutting expenses, or will you allow that benefit to enhance the bottom line instead?

Yes. So, a couple of questions in there, and thank you for acknowledging no normal environment has existed. But the structural piece, I would say, Steve, relative to Key over the last 20 years, but particularly going into the crisis, would be, I think the loan book profile is quite a bit different. So if you think about the quality of the borrowers, the 55% of C&I being investment grade, the structural differences in our CRE portfolio, the largely residential real estate, collateralized kind of super prime consumer, all of those things kind of lean you towards a little bit lower base NII just because of the quality of that portfolio.

I would add card as well.

I mean, yes, card, which we have, but it's highly transactor-based versus balance based. Now given that, you would expect credit losses to be better, and we think they will be certainly better than historically, but you would expect better on a relative basis. And your other question would be, okay, how do you monetize those clients to make sure that you're getting the right returns and getting business on it. We think we do that really well in the commercial business. We think we're doing that better and better as you go down market in commercial with things like payments, and we think we're getting much better on wealth and building the wealth business and the consumer space. So we think we're building those capabilities and have the opportunity to do that.

But I do think if you look back over time, there's probably a base structural nature of NII that's a little bit lower, given the quality of the portfolio. And that's very intentional. You've heard Chris talk about that at length. We have been tight on expenses. We've been doing that largely to maintain our ability to invest. And the short answer is hard to predict exactly what we do. I think it's a function of how much expansion do we see, how much investment capacity does that create? And frankly, how much high-quality investments are there in front of us? Our first investments are always going to be good clients and our people. And then in this world, you've got to continue to invest in technology. I actually think on an infrastructure basis, we've done a really good job on that over the last decade, and we'll continue to do that. But we're going to continue to make sure that we can invest and build the franchise the way we need to, to be competitive. And from an organic growth perspective, Steve, we obviously weren't doing our typical level of investment last year. But where you'll see us lean in, you'll see us lean into our unique integrated corporate and investment bank, where we've had a lot of success recruiting people. I mentioned earlier our 55 billion of AUM. We think that platform is eminently leverageable. We'll be investing in that. I mentioned also payments, and then lastly, I also mentioned business banking. Those are the areas where you'll see us leaning in from an investment perspective.

Got it. Okay. If I can ask one other question. Chris, it's interesting to hear you're so optimistic about credit. I mention this because if you listen to anyone else on CNBC, they all highlight the pressure on commercial real estate affecting regional banks like yours. Can you update the investors on the line right now about what's happening? You had commercial real estate loans coming up for renewal in the fourth quarter. I know you don’t have a large office portfolio, but I'm sure some of those loans came up for renewal. What’s the situation? Are you able to renew them given that the loan-to-value ratio was 60%? With a higher cap rate, are those loans being renewed? There’s a perception that banks are just delaying the inevitable. I’d love to hear your thoughts on what’s happening as these loans come up for renewal.

Certainly. We need to reflect on our past experiences, particularly the significant losses we faced in real estate during the financial crisis. We committed to never allowing that to happen again, which led us to completely restructure our business. We established an underwrite-to-distribute model, working with entities like Fannie Mae, Freddie Mac, FHA, life insurance companies, and the CMBS market. We also decided to finance only the top real estate professionals in the most suitable sectors and locations, maintaining a very selective approach. Currently, 13% of our loan portfolio is in real estate. On the ground, the situation we are experiencing reflects our careful selection process. When we identify loans that qualify as criticized, we request an interest reserve from the borrowers, who comply. Therefore, what we are observing may not fully represent the broader market. Our strategic efforts over the past decade have positioned us favorably now.

Again, we thank you for participating in our call today. If you have any follow-up questions, you can direct them to our Investor Relations team. This concludes our remarks. Have a good day all.