PNC Financial Services Group Inc (PNC) — Q2 2015 Transcript

Thank you and good morning everyone. Welcome to today's conference call for the PNC Financial Services Group. Participating on this call are PNC's Chairman, President and Chief Executive Officer, Bill Demchak; and Rob Reilly, Executive Vice President and Chief Financial Officer. Today's presentation contains forward-looking information. Our forward-looking statements regarding PNC's performance assume a continuation of the current economic trends and do not take into account the impact of potential legal and regulatory contingencies. Actual results and future events could differ possibly materially from those anticipated in our statements and from our historical performance due to a variety of risks and other factors. Information about such factors, as well as GAAP reconciliation and other information on non-GAAP financial measures we discuss, is included in today's conference call, earnings release related presentation materials and in our 10-K, 10-Q, and various other SEC filings and investor materials. These are all available on our corporate website, pnc.com, under the Investor Relations. These statements speak only as of July 15, 2015, and PNC undertakes no obligation to update them. Now I would like to turn the call over to Bill Demchak.

Thanks, Bill, and good morning, everybody. As you have seen today, we reported net income of $1 billion or $1.88 per diluted common share for the second quarter and that compares with net income of $1 billion or $1.75 per diluted common share for the first quarter of '15, and $1.1 or $1.85 per diluted common share for the second quarter of 2014. Our return on average assets for the quarter was 1.19%. Second quarter was largely a success for PNC despite low interest rates that continue to pressure net interest income across the industry. We grew average loans slightly linked quarter, driven by our specialty businesses in the corporate and institutional bank and we were up 3% year-over-year. Average deposits were up $4.8 billion or about 2% linked quarter. Expenses were well managed, although there are some moving pieces this quarter and Rob is going to step through that in some detail during his comments. Importantly, fee income grew 7% this quarter and 5% year-over-year as a result of our continued execution against our strategic priorities. As we said in the past, our priorities are aligned to deepen customer relationships and drive fee income growth, which enables us to create long-term shareholder value even in a low interest environment and we are making important progress against each of our strategic priorities. We continue to make good progress in building a leading banking franchise in the Southeast. On the corporate side, Southeast loans, revenues and cross-sell hit their highest quarterly levels since the acquisition of RBC Bank USA. In retail, loan and deposit account growth continues to outpace our other markets. Asset management also had a good quarter with new primary client acquisition accelerating both, year-over-year and linked quarter. In addition, fee income grew both, quarter-over-quarter and year-over-year. In retail, we continue to make important strides to transform the customer experience in accordance with evolving customer preferences. We continue to optimize our branch network. In fact, by the end of this year, we expect we will have closed or consolidated more than 400 branches, reducing the overall network by more than 10% since the acquisition of RBC Bank USA, while continuing to serve our communities. This includes plans to consolidate 100 branches this year. In the second quarter, we saw primary digital channel usage among our customers exceed 50% for the first time and non-teller deposit transactions via ATM and mobile are up almost 25% over the second quarter a year ago. We now have more than 300 branches operating under the universal model. Customers of universal branches have a higher percentage of deposit transactions via ATM and mobile and these branches complement the variety of touch points we have created to serve our customers in the ways that they want to bank with us. We are proactively engaging with our customers to set appointments for them to come and talk with us about their financial needs. We have expanded this. We started this last year and we expanded it across the retail network and our customers are responding. Today, through this program, we have contacted more than 1.2 million customers which resulted in more than 350,000 scheduled appointments, which in turn have led to more than 100,000 new product sales as we learn about their needs and they learn about the range of our products. Importantly, throughout all this, we remain a Main Street bank organized around the relationships we enjoy with the people in businesses we serve. Another area, where you have heard us talk about improving the customer experience is in residential mortgage banking, we and everybody else have spent a lot of time the last few years looking backward at systemic problems that plagued the mortgage industry for years. While there is still work to do, we can now begin to think more strategically about the future of our home lending business and the relative experience for our customers. In the second quarter, we were very pleased with the OCC's announcement that PNC was one of three mortgage service providers that had satisfied all of the requirements under the OCC's mortgage consent orders. As it relates to technology and operations, we are about midway through our multi-year effort to modernize our infrastructure and improve efficiency. Our efforts are on plan and we are beginning to see the benefits of our investments to make our technology infrastructure more secure, more reliable and more scalable. On the whole, it was a successful quarter for PNC. From a macro perspective, the operating environment is pretty much what we expected it to be at this point in the year. We continue to await some definitive indication of when interest rates will begin to rise, but in the meantime we are executing well on the things we can control. Furthermore, we remain sensitive to the revenue expense relationship and are in the midst of taking a number of actions to reduce operating expenses, particularly as we move into '16 and Rob is going to give you more detail in a few minutes. As we look to the second half, I am confident that we have the right people, the right model and culture to continue to deliver a superior banking experience for our customers and to create long-term value for shareholders. With that, I will turn it over to Rob for a closer look at our second quarter results and then we will take your questions.

Yes. Thanks Bill. Good morning, everyone. Overall, we had a strong second quarter with results that are largely consistent with our expectations. Second quarter net income was a $1 billion or $1.88 per diluted common share. These results were driven by strong fee income performance, continued earning asset and deposit growth, well-controlled expenses and improvements in credit quality. Our balance sheet on Slide 4, and is presented on an average basis. As you can see, total assets increased by $4.6 billion or 1% compared to the first quarter. Commercial lending was up $1.4 billion or 1% from the first quarter, which as expected was at a slower pace from previous quarters. The growth was driven by our specialty businesses, including commercial real estate and asset-based lending and by strong volumes around M&A financing in our large corporate business. To a lesser extent, modest utilization increases also contributed to the growth. Consumer lending declined $1.2 billion or 2% of which more than $300 million was due to the run-off of non-strategic assets, with the balance primarily due to decreases in home equity and education loans. Investment securities were up $2.3 billion or 4% linked quarter, substantially funded by deposit growth. Lastly, our interest earning deposits with banks, primarily with the Federal Reserve, increased in the second quarter commensurate with our liquidity management activities and strong deposit growth. On the liability side, total deposits increased by $4.8 billion or 2% when compared to the first quarter, driven by higher levels of demand money market deposits. Borrowed funds increased by more than $800 million or 1% on a linked quarter basis. We optimized our funding structure in light of a regulatory liquidity standard and a rating agency methodology change. As such, we issued senior bank notes, bank borrowings increased and we reduced commercial paper. Total equity remained stable in the second quarter compared to the first quarter as retained earnings were essentially offset by capital returns as well as a decrease in AOCI. Our interest earning deposits primarily with the Federal Reserve were $32.4 billion as of June 30th, an increase of $17.7 billion or 121% compared to the same time a year ago in part to comply with liquidity coverage standards, but also reflecting strong deposit growth. As you know, the Federal Reserve short-term liquidity coverage ratio went into effect on January 1, 2015, and as of June 30th, our estimated ratio exceeded 100% for both, the bank and bank holding company, under the month end calculation methodology. Turning to Slide 5, we continue to maintain strong capital levels while delivering significant shareholder capital return. During the second quarter, we repurchased 5.9 million common shares for approximately $600 million. This is part of our repurchase authorization of up to $2.875 billion for the five-quarter period, which began April 1, 2015. Period end common shares outstanding were 515 million, down 4 million linked quarter and 16 million compared to the same time a year ago. Risk-weighted assets on a fully phased standardized approach were essentially flat on the linked quarter basis. As of June 30, 2015, our pro forma Basel III common equity Tier 1 capital ratio also fully phased in and using standardized approach was estimated to be 10%. Finally, our tangible book value was $61.75 per common share as of June 30th, a 6% increase compared to the same period a year ago. Turning to our income statement on Slide 6, net income was just over $1 billion and our return on average assets was 1.19%. Our second quarter performance delivered revenue growth of $135 million or 4% on a linked quarter basis. These results were driven by strong fee income in virtually all categories, partially offset by a small decline in net interest income. Expenses remained well-controlled and we experienced improved credit quality. Let me highlight a few items in our income statement, core net interest income was relatively stable as higher earning assets were offset by lower yields and higher deposit expense. Overall, net interest income declined by $20 million or 1% compared to the first quarter due to lower purchase accounting accretion. Non-interest income increased to $155 million or 9% linked quarter due to strong fee income growth and higher gains on asset sales. Non-interest expense increased by $70 million or 1% compared to the first quarter as we continue to focus on disciplined expense management. This quarter's results include a change in the application of how we account for historic tax credits, and I will have more to say about that in a moment. Provision in the second quarter was $46 million, down $8 million or 15% from the first quarter. Now, let us discuss the key drivers of this performance in greater detail. Turning to net interest income on Slide 7, average interest earning assets grew by $5 billion or 2% linked quarter, primarily due to increased security balances, higher liquidity positions and modest loan growth. Core NII was relatively stable compared to the first quarter, driven by growth in earning assets funded by core deposits. Purchase accounting accretion declined by $17 million linked quarter. As a result, total net interest income decreased by $20 million linked quarter. Net interest margin declined nine basis points linked quarter, primarily due to purchase accounting accretion and our increased liquidity position. Regarding purchase accounting, given the higher than anticipated cash recoveries we experience in the first half of the year, we have revised our forecast by $25 million. As a result, we now expect purchase accounting accretion to be down for the full year approximately $200 million when compared to 2014 versus the previous guidance of $225 million. In terms of our interest rate sensitivity, our duration of equity remains negative. As you know, our balance sheet is asset-sensitive reflecting our view of the interest rate environment. As we said some time, we recognize it has and will possibly continue to constrain our NII growth in the short-term. However, when interest rates do begin to rise, we are well-positioned and we will continue to apply a measured approach to higher levels of investment activity. Turning to non-interest income on Slide 8, overall strong performance across our diversified businesses generated an increase in fee income of $91 million or 7% this quarter. Equally important, year-over-year fee income increased by $73 million or 5% reflecting our strategic priorities to grow higher quality and more sustainable revenue streams. Total non-interest income increased by $155 million or 9% linked quarter, driven by core fee growth and higher gains on asset sales, asset management fees increased by $40 million or 11% on the linked-quarter basis. During the quarter, we had a substantial trust settlement resulting in fees of approximately $30 million. In addition, market performance and new sales production also contributed to the increase. Compared to the same quarter a year ago, asset management fees increased by $54 million or 15%, excluding the substantial trust settlement in the second quarter, asset management fees were up $24 million or 7%, primarily due to market performance, net new business and BlackRock earnings. Assets under administration were $262 billion as of June 30th, up $5 billion or 2% compared to the same period a year ago. Reflecting our strategy of growing share of wallet in retail, consumer service fees were up $23 million or 7% linked quarter, with increases in all primary categories reflecting seasonality and higher client activity. Corporate services fees increased by $25 million or 7% linked quarter. Compared to the same period a year ago, they increased by $26 million or 8%. In both periods, the growth was primarily due to increases in treasury management and capital market advisory fees. Residential mortgage non-interest income was flat compared to the first quarter as double-digit originations growth was offset by our first quarter portfolio sale. Mortgage originations were $2.9 billion in the second quarter, up from $2.6 billion the same quarter a year ago, a 14% increase. Services charges on deposits grew by $3 million or 2% linked quarter, primarily due to seasonality and higher client activity. Compared to the same quarter a year ago, deposit service charges declined slightly as a result of evolving customer behavior related to product changes. Other categories of non-interest income increased by $64 million, primarily from gains on the sale of Visa stock offset by lower net securities gains. Total non-interest income to total revenue was 47% in the second quarter, up three percentage points both, linked quarter and the same quarter a year ago. Turning to expenses on Slide 9; second quarter levels increased by $70 million or 1% as we continue to focus on disciplined expense management. We recorded a $43 million increase in personnel costs in the second quarter, resulting from higher variable compensation costs associated with elevated business activity. In addition, equipment cost increased reflecting our investments in technology and the bank transformation. Partially offsetting these increases was a change in the application of $54 million of year-to-date historic tax credits to related asset investment balances. This had the effect of lowering impairment expense and correspondingly increasing income tax expense. In simple terms, because of this change, non-interest expenses decreased by essentially the same amount of the income tax increase, and by definition is EPS-neutral. We made this change in presentation to better align with industry practice. As a result, our second quarter effective tax rate was 28.2%, up from 24.4% in the first quarter. With this change, we now expect our full year effective tax rate to be 26%. As you know, the goal of our 2015 continued improvement program is to reduce costs to fund the investments we are making in technology infrastructure and retail transformation. In our first quarter earnings call, we referenced an effort to enhance expense savings over and above CIP target of $400 million. During the last couple of months, we have identified initiatives that support increasing our CIP goal by an additional $100 million. As a result, we have raised our 2015 CIP goal to $500 million. When looking at the full year 2015 expense forecast, take into account the benefit of the tax credit change and the additional CIP, partially offset by higher variable incentive comp and investments related to equipment expenses. We have revised our full-year 2015 guidance from stable expenses to down approximately 1% compared to full year 2014 expenses. As you can see on Slide 10, overall credit quality improved in the second quarter compared to the first quarter. Non-performing loans were down $153 million or 6% compared to the first quarter as we saw continued improvements across our commercial and consumer loan portfolios. Total past due loans decreased by $109 million or 6% linked quarter. Net charge-offs of $67 million declined by $36 million or 35%, primarily due to strong recoveries in commercial lending. In the second quarter, the net charge-off ratio was 13 basis points of average loans, down from 20 basis points in the prior quarter. Our provision of $46 million declined $8 million or 15% linked quarter as overall credit quality improved. Finally, the allowance for loan and lease losses to total loans is 1.59% as of June 30th. This compares to 1.72% at the same time a year ago. As you know the shared national credit exam has been completed and our results are fully reflected in this quarter's reserves. In regard to our oil and gas exposure, we have a total of $2.6 billion in outstandings, which is down about 10% from the first quarter and still represents about 2% of our total commercial lending portfolio. Of the $2.6 billion, approximately $300 million is not asset-based or investment grade. In our view, these loans have the potential to be the most impacted by the drop in oil prices and we continue to monitor these loans closely. Importantly, we remain comfortable with our current reserve levels based on our continuing review of the portfolio. In summary, PNC posted strong second quarter earnings consistent with our expectations. We continue to believe the domestic economy will expand at a steady pace this year. Our plans assume the Federal Reserve will begin to raise short-term interest rates beginning in September. Given this background, we expect total revenues to continue to be under pressure, primarily as a result of lower purchase accounting accretion. As I said earlier, we now expect full year 2015 expenses to be lower compared to full year 2014. Looking ahead to the third quarter and when compared to the second quarter reported results, we expect modest loan growth, we expect net interest income to remain stable, we expect fee income to be stable as we anticipate the continued growth and business activity in the third quarter to effectively equal the elevated second quarter trust settlement fees. We expect expenses to be stable and we expect provision to be between $50 million and $100 million. With that Bill and I are ready to take your questions.

Operator, can you give our participants instructions please?

Yes. Good morning.

Good morning, Erika.

Good morning.

My first question on the base for the fee income guidance for next quarter, are we keeping the $30 million unusually large trust settlement in the base? If so, what is the usual run rate of trust settlements that you typically recognize and where is the core growth coming from if that is indeed included in the base of your guidance?

Sure. Good morning. This is Rob. The answer of the part one of your questions is, yes, it is the base, so we do expect across all of our fee categories in the third quarter to effectively grow those consistent with our strategies in an amount equal to that $30 million trust fee and that is we had guidance in terms of being stable. In regard to the second part of your question in terms of the trust settlement fees, that is a routine thing that happens in terms of any trust business. What is unusual about this one is it happens to be one of our largest trusts and the period in terms of which was involved with was particularly long, so that is why we called it out. The usual run rate of settlement fees is in the low millions of dollars in particular quarters, so this one is not unusual by its size.

Got it. My second question is for Bill. We have been asking your peers over the past few calls in terms of their take on deposit beta and hopeful anticipation of a rising rate environment in the back half of this year. JPMorgan mentioned that they think that the betas there are going to be much greater, because of new regulatory standards. Wells took a softer stance saying that we are coming from zero and USB was somewhere down to middle. Where do you stand?

We are probably closer aligned to JPMorgan, and I think there is going to be a pressure, particularly on the retail side, just given the differentiation in LCR qualification retail deposits versus wholesale.

Next question please?

Good morning, Scott.

Good morning guys. Rob maybe best for you just I want to make sure I am starting off the right base on the expense guidance for the full year down 1%.

Yes.

Is that off the reported at $9.488 billion from last year or I assume recalling the fourth quarter last year you had something like $125 million of unusual costs, which would have taken it lower, but whatever the base is?

Yes. Sure. It's off the reported numbers.

Okay. Perfect. Thank you.

Sure.

Then maybe just another question on kind of how are you thinking about the margin and balance sheet growth dynamics as we look for a stable NII into the third quarter? I appreciate your updated thoughts on the purchase accounting down, I think you said down $200 million. As you look at things, so is margin pressure abating in part because of that which allows you to do NII, or are you thinking you grow at a more rapid clip? How do you see the interplay coming out?

Well, there are a couple of things going on there. On the purchase accounting accretion, the revision there really reflects greater than expected recoveries in the first half of the year, so that is a good thing. We keep saying as we get deeper into this, the opportunity for recoveries becomes less but because they were so substantial in the first half, we have revised that to down $200 million versus to $225 million. In terms of stable NII, it is pretty much consistent with the theme that we have been saying all year, fighting the lower rates offsetting that with modest growth in our loan portfolio, which we expect to continue albeit at a somewhat slower rate than what we have done historically and putting some more money to work in investment securities in a measured approach.

Okay. Good. I think that is great. Thank you very much.

Sure.

Next question please?

Good morning.

Good morning, Matt.

Can you just talk about the desire to deploy some of the liquidity? Last quarter, I know you added to the securities book, but if we look over a longer-term period it does not seem like you have kind of built the securities or mortgage book as much as we have seen in some other banks and obviously rates have backed up a little bit here, so just curious on thoughts of easing into it around these levels.

Yes. Tactically, if you look through time the securities book would kind of go up or down depending on where we were in long-term rates independent of the front rates being zero. We have obviously sold off in the back and a lot since the end of the first quarter and that is part of the reason you see our security balances increasing and you will likely see them increase as we go forward and just kind of step our way into what we think is going to be a rising rate environment. We have an ability against, I do not know what it is, $32 billion, we have sitting at the Fed today. We can obviously redeploy most if not all of that into other interest-bearing assets Level 1 LCR and then some percentage of Level 2, where we still have, what is it 40%?

$13 billion.

…so big number that we could put into Level 2, but that's all against - We do not think about where you put the cash, we think about it in terms of the duration, the balance sheet and where we are investing in long-term rates, which can be done through swaps, through loans, buying securities and reducing cash.

Okay. Then just separately on expenses, as we look maybe a little bit more than just the next couple of quarters and think about next year, you know, maybe we get less benefit from rates than folks saw just six months ago. What are your thoughts on being able to control costs in a still low rate environment as we look out beyond this year?

Yes. Sure, Matt. This is Rob. We are not in a position to be able to give guidance on '16 specifically yet, we will get to that when we set our budget up in the fall and get a feel for where we are particularly around interest rates, but the message that we want to convey again this morning is that we are very mindful of the revenue-expense relationship. We do feel in terms of the way that rates were pushed out, our expectations of a rate rise were pushed out there in first quarter earnings call necessitated this additional push on expenses which is why we raised our CIP target.

Just as an aside, part of the story on expenses this quarter in variable comp, Rob talked about basically out of variable incentive as well as pretty much expected equipment cost increases as we continue with the technology agenda. On the variable comp piece, perversely at the start of the year, we changed some of our incentive programs in retail to drive deposit growth, which we have absolutely gotten. You see the acceleration in our deposit growth on the retail side. What we have not gotten is the value from that growth in deposits is rates against our original forecast to remain lower for longer, so the pop in incentive comp, but we can get the offsetting revenue and it is something we have the ability to dial as we go through the rest of this year.

Yes. What I would add to that too is, I would encourage you to focus on the full year expense management. We can get as I said this for a number of years, we can get quarterly fluctuations around those types of things and also our pace of investments that are not necessarily uniform to the quarter, but are for the year.

Okay. Thank you very much.

Next question please?

Thank you. Good morning guys.

Good morning.

Can you guys share with us your thoughts, you mentioned that you are likely to close I think another 100 branches this year for a total of 400 over the last three or four years. Can you share with us the deposit retention? What kind of numbers are you seeing when you consolidate these branches? Are you keeping 90% to 95% of the deposits?

Yes. Hey, Gerard, it is Rob. A couple of things there, one is as Bill mentioned, we have plans to consolidate 100 branches in total for 2015, 50 of which have already been consolidated, so there is an additional 50. So far in terms of what we have done in terms of these consolidations, the deposit retention has been very high. I do not have an exact number for you, but obviously that is one of the sensitivities and we manage it pretty closely.

What type of feedback have you received from your customers whether it has been positive or negative on these consolidations?

More often than not, it is not positive, but having said that we have very long lead times in advanced warning to affected customers and warm handoffs on moving people up to their branches. As you would expect, we get the occasional complaint when we do consolidations, but we are quite thoughtful about how we go about it in the lead time, the lead times associated with notifications and follow-up customer service.

You have talked over the last couple of years about the upgrading of the internal technology and it looks like the light at the end of the tunnel comes possibly in the second half of next year or toward the end of next year. After that is finished, can you give us your views on what you are thinking about mergers and acquisitions once this task is behind you and you may have a better ability of doing something on a go-forward basis?

Sure. I think, we said looking backwards that our technology agenda trumped our desire to look at retail bank acquisitions. We did want to stop what we were doing, to do integration. When the technology agenda is at a point where we can in fact do that, it does not mean that we are then going to get into an acquisition game. We will look at the environment at that point in time, look at values in the market and look at in our strategic needs and opportunities and have a view, but that is a year and a year-and-a-half from now. It will depend on rate environment, it will depend on the continued change in retail preferences and the transformation we are going through and we will evaluate it when we get there.

Just one final thing on the technology, some banks that have done similar projects that you are doing right now, talk about the capacity of their systems now are twice the size of their current bank balance sheet. Do you have any guidance on what your system will be capable of, not to suggest you are going to do something really big, but can you give us some flavor for how big your system could handle in terms of assets?

Yes. That is too broad of a question to answer specifically, because it obviously depends on the type of activity, but I would tell you historically our challenge was we couldn't scale our activity without scaling the cost along with it, because we had much more manual process than we otherwise wanted. A big part of what we are building out in technology through automation is the ability to scale without adding variable cost associated with it, so I think we can do material. Once completed we could do materially more volume than we are doing today, importantly without adding to the personnel costs that typically comes along with that and that is what we are building into this plan.

Great. Thank you.

Next question please?

Good morning. Thanks for taking my question. We have heard on a couple of calls the challenges that a lot of the banks are seeing in terms of generating loan growth on the commercial side and I know that you all feel quite comfortable being able to bring more of the fee income component to these relationships, so that you are not just sort of chasing rate, but can you give us an outlook on sort of how you are thinking about commercial loan growth, specifically within the C&I space? I guess, also sort of where the M&A financing outlook might be to drive further growth in the commercial side of things?

Yes. I mean, I guess is a bunch of comments into that space. First of if you look at our growth in C&I relative to peers, at least peers that have reported this quarter and it do not surprise us, we look light and that is coming off of. It is interesting to go back through time, our growth outpaced peers during the crisis in a slowdown as everyone else accelerated, which is typical of our strategy in the sense that the highest returning loans typically are made in times of crisis. What has happened are a couple of things. One is, a lot of the volume increase you see particularly the large banks is on the back of large corporate M&A activity. We have some of that in our growth rate, but we are more of a middle market bank than a large corporate bank, so we participate less in large corporate growth and some of the big banks. In the middle market space, specifically, has been really competitive. We have not had outright growth in vanilla middle-market loans I think going back five or six quarters rather.

Easily.

…and instead have continued to have and still have growth in our specialty segments of business credit and leasing and real estate and some other things we do. Interestingly, one thing that has impacted the front half of this year, which is somewhat is somewhat new, is some of the loan-only relationships put on you know during the crisis at very wide spreads, a lot of them in the financial. We report them as financial space, but some of them could be securitization-type activity. They have refinanced and re-priced at levels that make no sense to us, particularly in light of the penalties associated with those types of loans under LCR, so we purposely shrunk our FSAB balances while we focused on cross-sell, broader commercial relationships and that is part of the reason you see the slowdown in our growth line. I think you know that the growth going forward and Rob talked about this, we expect kind of moderate growth in the C&I space and continue to be challenged in the retail space as we continue to see run-off in education loans and some of our legacy books.

Then if I can just follow up on credit, Rob, you mentioned the energy exposure, oil and gas exposure is down about 10%.

Yes.

…and it is still a pretty modest portion of the overall portfolio. I presume given the fairly meaningful decline in NPAs and provision this quarter suggest you did not do much in terms of reserve increases on that portfolio, but could there be a second borrowing base review later in the year that could drive further reserving on that portfolio?

Yes. A couple of things there, one is the 10% decline is in our outstanding that I have mentioned as opposed to our exposure and we feel good about the reserve levels I had mentioned, particularly on that roughly $300 million of loans, which is asset-based or investment grade. We have done some reserving. You will recall in the first quarter, we had mentioned we had done some QFR qualitative research and we have changed some of that around, around some specifics, but no net day change. We will continue to monitor the portfolio closely going forward, but there are not any plans for a big change. We will just continue to watch it as it develops.

Thanks very much.

Next question please?

Good morning.

Hey, John. Good morning.

I wanted to see if you can give us some additional color on the incremental $100 million in the CIP saves. Just generally where is that coming from? What type of programs? Also, does that have a revenue impact at all from these items? Then lastly, it does imply that the tail end of the year, the fourth quarter should decline substantially in terms of expenses in order to meet that number 1% down guidance, so just wanted to make sure I understand that correctly and what is driving that?

Sure. A couple of things there, one is, generally speaking the additional $100 million is a result of a broad belt-tightening across the organization. We announced it on our first quarter earnings call, our employees all heard and we all rallied around that, so there is not any big number that is driving that. What I would say is, a big portion of that is coming from reducing our planned expenses around staff services which had grown over the last couple of years, which we told you about. Do not really count for a big change in revenue as a result of that, so our revenue guidance stays the same. Then if you take a look at expenses in terms of sort of the second half of the year around that 1% sort of math. Approximately second expenses need to match our first half expenses, which is what we are saying.

The other thing I would mention is, the $100 million of incremental CIP that we focus on this year is in fact what we will realize this year, that gives rise to a, you know, entry-level as we get planned for '16. A big part of this exercise is to make sure we are holding expenses down in '16 given that rates you know not only were going to start going up later, but also go up slower. In many ways, this was less about what we were going to do this year and more about what we were going to do in '16 and the out-years.

Being positioned to gradually rising rate environment, shallower than what we previously thought. As an example, inside of that 100 branch closures number that we put forth that is inside of our expense rate, right, so there is no one-time. We buried the cost associated with shutting those down and canceling leases and so on and so forth as opposed to announcing a one-time charge associated with closing 100 branches, which other peers have done.

Okay. All right. Then, Bill, getting back to your comments you just made around competition in the mid-market space in C&I, I know you have been talking about that and it certainly sounds like it is still competitive, so my question is, from your perspective, what changes that? I mean, as the size of the pie grows and demand improves across the board here, does that allow you to step back in or are you skeptical of that as well?

I do not know exactly what is going to change. What I would tell you is, it is interesting to me that spreads for the first time in I do not know, 10 quarters were basically flat this quarter, so maybe we have hit the bottom at least in this rate environment. If you go way back in time, you would say that deposit balances in loans inside of banks historically have roughly been equal, with given your loans might grow faster than deposits, but they kind of tend to equal out. We have been in a period of five years, where deposits have massively outgrown loans. You will hear different people, the dialogue in the industry is as it normalizes to mean revert, is that going to happen by deposits shrinking or by loans growing, so U.S. bank thinks there is going to be a big loan growth spark. I hope they are right. Morgan and ourselves are probably on the camp that we are probably going to see deposits shrink, but somewhere in there I mean, as we play forward here, status quo, I do not know what is going to change to cause pure middle-market lending-only relationships to be any more attractive, which is why we are focused so much on growing fee income in the cross-sell relationships.

Okay. All right, that is helpful. One last quick thing, did you provide updated purchase accounting accretion expectations for 2015?

2016? No. Not yet.

Okay. For full year 2015?

For full-year '15, down $200 million that has changed from the previous guidance of down $225 million.

Got it. Okay. All right, thank you.

Next question please?

Sorry about that. Thank you very much. Can you go back a little bit on the follow-up question on the competition out there? You define yourselves as a middle-market type of bank. Can you define what really middle-market is, because I think it has different definitions for different people.

It is a fair question. We probably think about it just in terms of the way we organize ourselves from call it $30 million to $50 million up to $500 million. Practically it is $50 million to $1 billion.

In terms of annual revenues.

annual revenues, so our sweet spot that kind of fits our product set and then we target is $52 billion in revenues. Having said that, we have a number of clients given our treasury management capability and some of the specialty products we have that are better obviously much, much larger than that.

Then you have - really, I think if you guys you might not think of it, you have the legacy part of your institution and then the southern part, where you got with RBC. Are you seeing - I mean, that is an area you said that you have going in and really got a lot of credibility and some influx really quickly. Are you being able to bank that middle-market down there also or is that also just as competitive as you are seeing in your traditional sites?

We have actually grown it faster by every measure, you know, into our newer markets. It is just as competitive, but I think you will having an alternative offerings in some of those markets, bringing the other products that we can to bear, particularly in the treasury management side makes a difference. Having a great team of people, that are combination of terrific people we hired during the downturn and legacy PNC employees that we moved down there, so now in the end we are actually outpacing our more mature markets and in the newer markets.

Some of that just is reflective of a smaller base.

Yes. Then the last question is, what do you think drives out some of that? What do you think that to sum this competition gets driven out? I mean just solid economic growth or what can we look for in the outside to see that you started getting some pricing power in this middle market area?

Well, I think you have to be careful to not just focus on loans, so one of the things we look at internally a lot is our loan growth versus our total revenue growth inside the CNIB space. You cannot have a sustainable environment, where you are growing loans of 10% and your revenue at 1%, which if you dig through some income statements you will see a lot of people doing that. We focus a lot on making sure that we are growing total revenue at a pace that is commensurate with the capital we are deploying, which I think ultimately allows us to provide a good return to our shareholders. I think people who are chasing loan growth and the thing that ultimately changes, they realize that is not sustainable in terms of providing return on equity to shareholders, I do not know that people have figured that out yet, but lending-only relationships in the middle-market space if that is your business plan without a product set to support it, I do not think is sustainable.

Okay. Hey, guys, thank you very much.

Yup. Next question please.

Thanks, good morning guys.

Hey, Ken.

Rob, I appreciate the color on the second half expenses and I was just wondering, can you just help us understand that mechanism in terms of the tax change, so the $54 million that was in the second quarter, was that a catch up? Was it a one-time? Then just in terms of how that goes forward?

He is so happy that you asked that question.

Yes. I am glad you asked that question Ken, because the $54 million really reflects the total first half of '15 activity. It is a lumpy business, so virtually all of our sort of tax credit business in the first half of the year, we did in the second quarter. The best number that I can give you for the full year number is $80 million, which is our budgeted number that we budgeted at the beginning of the year. Again, it is a lumpy business, so we could do a little bit more than that, we could do a little bit less than that, but that is not a number that you would annualize. For some context, total tax credits in 2014 were $75 million, so that fits in with that $80 million.

Okay. That is helpful, so it is…

Also, Ken, just on that. That is the $80 million is what we used for the math to give you the guidance on the effective tax rate at 26%, so that is why you say…

Yes. Right. I was going to say that, that was implied in the $26 million for the year is, that it would not run at this $54 million?

Yes.

…so you are just trying to give us a best understanding of kind of a generic, what seems to be kind of volatile, but business you do on a recurring basis.

That is right.

Okay. Next question please?

Thank you. Good morning. Can you guys discuss the quality of the money market and demand deposit growth that you saw this quarter from an LCR perspective? On a related note, on the initiatives that some banks have undertaken to deemphasize non-operating deposits, do you have any thoughts on where those deposits are going?

Well, on the money markets side it shows up on the retail segment, they are all LCR-friendly, all good and we have been pleasantly surprised and tracking aggressively, obviously, the retention of new money, new clients. Interestingly, the balances for new households are higher given our product offerings than they have been in our history partly changing our checking account mix. As it relates to operating deposits for corporate, they are less valuable to us from an LCR standpoint. They are still valuable and we still obviously have room on our leverage ratio and the ability to hold those, so inside of our corporate space it would not surprise me at all that we are getting some growth in corporate balances that is coming as a function or some of the that are constrained pushing those away.

That is very helpful. On a separate note, relating to fee income, some folks that we have spoken with have expressed a little bit of skepticism surrounding the sustainability of your fee income growth. Bill, could you discuss what is underlying your confidence and your ability to sustain the kind of growth trajectory that you guys are experiencing as we look forward from here?

In its simplest form, we are simply suggesting we are going to continue to do what we have done for the last. Maintaining trajectory. A couple of years, and each one of those line items kind of drills down to a specific business plan that does not assume heroic assumptions to be able to accomplish it. On the corporate side, the growth you are seeing and we have talked about is coming on the back of cross-selling all the new clients that we onboarded during the crisis. We had 10% compounded primary client growth and CNIB for two or three years running during the crisis that we are largely lending-only relationships. We now have the ability to monetize that through cross-sell. In the retail side, it is on the back of the continuum change of what we did with the product offerings, elimination of free checking, the continued growth in merchant, debit, and credit card where we are underpenetrated and well fits what we have not done for five years and using the rest of the organization to refer business and cross-sell. There is nothing heroic in there. We are hitting on all lines of business against this general notion that we put forth as a company that we want to be less dependent long-term on net interest income to drive this company and be able to get back to a more historical balance that we used to run at in terms of fees and net interest income, so we are just prioritizing. People get it is important.

That is great. Thank you. That really helps a lot. If I can squeeze one last one in relating to just a follow-up on your comments surrounding the deployment of your excess liquidity, one of your peers indicated yesterday that the 10-year U.S. treasuries at around 2.5% represented an attractive asset in the rate environment that we find ourselves in and they were comfortable extending duration a little bit. You mentioned, Bill, that your securities balances should start to rise from here as you stepped your way into a higher rate environment, does that mean that you are also feeling a little bit more comfortable extending duration now than you did say a quarter or two ago?

We like the 10-year a lot better to 240 than we did at 179 or wherever it hit towards the end of the first quarter. I think and I listened to that conversation you are talking about. Look, I think at the end the long ends going to have a slow grind higher. We have deployed, as you saw this quarter, a little more cash into the securities book. We are never going to make a single big bet that is not who we are. We are going to increment our way in as rates change here and we have a large opportunity to do that relative to the way we are invested today. One of the things that I should have mentioned, we talked about loan growth as our residential mortgage holdings on the whole loan side, which are obviously also a form of fixed rate duration. While we keep kind of jumbos in some of the production from our mortgage company, it is a lot smaller percentage and an opportunity for us, but it is a lot smaller percentage today than many of our peers, so we have a lot of ways to play here. I think by and large, nobody is expecting a massive sell-off in a long and there is more value here today than it was a quarter ago. Even on the mortgage side, some of the adds we did, we are actually in mortgage-backed securities that OAS spreads on mortgage-backs are much, much wider than they were three months ago, so there is an opportunity there.

Thank you. Very helpful.

Thank you very much.

Technology issue.

We will answer Marty's question.

Well, hang on. Is Eric on the online?

I am. Yes.

Okay.

Just to follow up on two issues very quickly as we wrap up the call here. One, Rob, I just wanted to make sure I understood your commentary about loan growth across the newer geographies. It seems like sort of the run rate for the industry is somewhere in the sort of 6% to 8% annualized level, but did I understand your commentary to mean that it is in line with that off of a low base, because intuitively it seemed like it should be somewhat greater than the industry average just given the starting point.

This is Bill and I think I was the one who was talking about that. I actually I do not know the percentages down there, but they are going to be higher there.

Materially, a little bit higher.

Okay, great. Thanks. Then my second question is, Rob, in the context of your commentary that as rate expectations changed, you had to make some changes to your expense outlook, but you may be at this point in the minority of thinking that the next Fed hike is coming in September. If in fact that gets pushed out by a quarter or two, would that necessitate another change or did the change you make anticipate potential additional slippage?

It is a good question. The change that we made was the reaction in April, when we pushed back those rates. If rates do not rise in '15, in that September hike, that is really not necessary expense related. We have bracketed that around in terms of NII. It is not a huge number. The bigger issue as Bill pointed out, relative to '16 and beyond in terms of the gradual rate rise. That is a much, much bigger impact to our revenue.

Okay. With that we have passed the time, so we are going to wrap up the call. Thank you all for joining us and have a good day.

Thank you.

Thanks.